The Future of IT Distribution

I sampled distribution as my second job after starting life at HP as a fresh-faced graduate. That was mid-eighties and if I am really honest about it the fundamental issues in distribution haven't changed drastically. We still talk about vendors, stock, margins, credit and marketing co-op.

It is fair to say that there has been a lot of consolidation which has brought about a small number of 'super-broadliners' who operate on a wide scale though none of them are truly global. But there are also quite a large number of more specialist distributors and there are plenty of small to medium sized players who service specific markets by products lines or geographies who do very well. What has changed is the overall volume bought through what we describe as 'The Channel' over that time and its importance to vendors.

I remember, as a young General Manager, when Digital invented its Green Space/White Space policy and tried to preclude the Channel from playing in their major accounts and Peter Herke grew DEC Direct to take over. That strategy probably plotted the pathway of destruction of one of the industry's finest businesses. It ended up in the hands of its worst enemy, HP, after scoring an own goal of monumental proportions. That own goal was to underestimate the importance of Channel in the dynamics of the market.

So, after all these years of importance, why are we suddenly saying that the Channel, and specifically distribution, has to change?

Many analysts bring up the concept of 'Value'. The most common misconception of distribution is to say it is only good for moving product in the market and handling credit. So for that, vendors think they should 'pay' no more than a slight premium on what they would pay a good carrier. That might describe hardware, but software has been a different for quite a while. In fact, boxed software only really exists for retail shops these days.

But there is a change happening that is fairly fundamental. The Cloud does create new possibilities. Most large distributors talk of The Cloud as being something that may build momentum over time and then they can play 'catch up' as time goes by. I think that's a mistake.
You see, the writing is on the wall. Hardware distribution is perceived as 'valueless' buy vendors and at one of the scale broadliners are offering new concepts of logistics-led services such as not actually buying and selling but just logistics. That model has only so far to go as ultimately distributors rely on carriers to ship which means only the warehouse space is left and maybe some invoice printing on vendor headed paper. This, to my mind, is one of the shortest lived strategies possible for distributors as they are effectively opening hardware distribution up for logistics companies. This model does not even include credit - it is just distribution leveraging its contracts with carriers.

The other area that is open to large distributors is 'White Goods' like consumer electrics. Esprinet in Italy already trades handsomely on this. In fact, so simple is this form of distribution that its model is more attractive in terms of margin opportunity than high end storage and servers. The big trick is credit as there are tons of small resellers as well as big retail chains. That usually means small credit lines and higher margins. Nice business.

All this detracts companies from what is happening in software. The assumption is that, at some future point, distributors will just become 'aggregators' of software via some kind of portal. Most are looking at working with some kind of hosting centre and then trying to fathom out how on earth they would charge and make money.

But there is a risk here. Having been through the early SaaS model at a vendor, we decided there was no need to use traditional Channels. You see credit was not an issue - we never did a credit check on any company, large or small. If someone did not pay a bill, we simply cut off the service. Despite monthly charges, most companies paid us the annual fees upfront with no discount offered. We only gave discount for multiple year deals.

We used different Channels to offer pay-as-you-go, by-the-minute services as this suited us. And so some users received the service as an event based rental or over-flow facility. Gross margins overall were 80+% as a vendor and there were few middle men and not one classic distributor or reseller. In fact, the major player in that market, WebEx, finally got bought by Cisco for $3.2bn without ever having a real Channel. We got bought by Microsoft and most of the technology got bundled.

There is a real danger here that unless a distributor shows leadership, creates a Channel proposition that can be understood, then the software market could drift away. Years ago, with two partners I started a business based on this precise assumption - over time the Channel role in software distribution would profoundly change and, at best, a whole layer would get removed as it was not required. The three of us still like to think we were precursors to electronic software distribution but we were men of the Channel and we knew the world would change. Maybe not quite then.

This time around, it will change. Aggregation of software will not be good enough in itself. There will be many other services around The Cloud which will be equally if not more important. For instance, one of the biggest arguments for The Cloud for large companies will be comparing financial models. Where do you start with that? By auditing current assets. Most large Corporates either don't have a good handle on what software assets they have or have weak understanding of licensing. Either way, it's fair to say most large companies are overpaying substantially for many products and services they receive from power to telecoms to software. Quantifying that overspend is crucial to justifying The Cloud.

For larger vendors, getting their software into the high volume of SME companies has been a perennial issue. Today, the Channel has an important role in that specific supply chain. That will not last much longer as I believe there will be companies who will offer software from multiple vendors to SMEs who do not form part of the Channel today. Look at Amazon and The Cloud for a sneak preview but look at how Tescos and food retailers have muscled in on the mobile market to understand that players from 'left field' have plenty of profits to invest in a huge opportunity. And then there is Private Equity - always ready to back potential game changers. On top of that, I don't for one minute believe that the likes of Facebook and LinkedIn are not looking at additional models to make money to justify their astronomic valuations.

I read recently that one major, more specialised distributor, was refining its strategy to focus only on a small number of major resellers and the rest could get a 'Lite' version of its service. I think that company will die with that kind of old-distribution mentality. Because the smart money will be exploitation of the mass accounts where their skills to leverage vendor relationships and 'electronic logistics' should yield higher margin business. The argument would be to minimally service large resellers as that opportunity will surely give less value and margin opportunity over time. Heck, we all know how little money there is in selling highly technical goods to someone like Computacenter. That is not a sustainable business model.

So some distributors will see the Blue Sky through The Cloud. I have read a fair bit about Blue Ocean strategies where businesses have moved out of crowded markets into calmer oceans which yield higher profits. The problem is that most distributors think there is no money to be made in The Cloud today.

That's because they don't understand it. By the time they react, it will be late and it will cost more to get in, against a backdrop of their traditional business suffering under higher pressure.

My message is 'Invest while you have the money'. Investing when you don't have the money is a lot, lot harder.

Sunny, With Dull Patches

So Oracle has bid $9.50 a share for Sun Microsystems, valuing the US hardware fallen giant at $7.4bn. It's a far cry from what Sun might have been worth a few years ago but it currently is worth a 42% premium over Friday's closing stock price for Sun - how the mighty have fallen.

IBM had tried to secure a deal with Sun last month but nothing came of it. To be frank, it may have been a more natural fit in some ways - two hardware vendors with software and services interests combining to plug the gaps in each others' portfolios. But the recent past has seen the once mighty Compaq get severe indigestion when it took over the lumbering has-been Digital only to see the failed combination being bought by HP under Carly Fiorini.

The fact is, Oracle is a software giant and although threatened by the likes of IBM, in reality the two models are poles apart. The computer industry has always segmented the business models of software and hardware. Many hardware companies had software interests but they never really came to the fore and dominated any specific space. Similarly, some software companies have had some hardware interests but again, none that ever really dominated a sector.

The plain facts are that software is a gross margin rich business model with development costs underpinning it. Hardware has seen its gross margins eroded, made worse as each vendor has attempted to service major supply agreements as Prime Contractors and therefore had to buy other hardware vendor products in at reseller type margins, often securing long term supply at single digit margins on other vendor equipment and so dissipating its true gross margin on deals. It has been the nature of the beast in getting revenue growth at the cost of profit. Dell, in particular, has felt the pinch using this tactic.

So what would happen when you combine the two models, particularly of two giants of their specific sectors? I have to say, that the jury is out for me. Sun made a walloping $1.9bn loss last year on £13bn of sales but Scott McNealy, the colourful Chairman behind Sun, reckons that Sun will contribute $1.5bn of profits this year and $2bn next year to the new group.

Industry Speak

Industry analysts reckon that Sun's customer list will give Oracle access to those customers who are not currently using their database products. How often have we heard that kind of speak before? The fact is that hardware vendors rarely 'own' their customers in the way that a software company does unless they have a major stake in their applications or infrastructure. The chances of Sun dictating what database it customers use are pretty slim to say the least. Moreover, it is not as if Oracle is not known in the corporate world so that Sun customers will not have heard of them - all in all it's a silly argument and would be similar to Microsoft buying Apple to force their operating system and products down the throats of Apple customers.

The best way to make such a combination work is to produce database-engine boxes which were tuned in performance to run Oracle applications - 'Appliances' if you like. The storage industry has a number of such products and giants in this sector like EMC and NetApp have acquired strongly tuned software products to work specifically with their hardware.

But such an avenue is fraught with danger, as EMC has seen in acquiring VMware. As great an acquisition as that was (EMC got its money back by floating just 10% of VMware stock), the issue was always that VMware had to remain independent of its parent in order to remain the credible market leader, particularly with Microsoft gearing up to get on the attack. If VMware were to favour its parent by tuning performance or showing preference, long term it could ruin its position with the likes of HP, IBM, Dell and others and so allow Microsoft in as the 'independent vendor' who was hardware agnostic.

This is the danger for Sun-Oracle. If Oracle tries to leverage its new hardware purchase by tuning the performance to the hardware or showing preference in development, then the vast array of hardware vendors will slowly but surely get jaundiced and it allows a gap for an independent supplier with good brains and products to win their hearts as there is no vested interest. Right now, HP or IBM executives who have a strong relationship with Oracle, are probably thinking that all their Oracle installations are potential Sun Microsystems targets.

Long term that may not be proven to be the wisest of choices. If you are going to buy a hardware vendor as a leading software supplier, make sure you buy the biggest as your first step, not the cheapest, as you may just have bought yourself not just a chump but a liability that will lose you a lot of friends.

What may have started as a plan to strengthen Oracle's position against IBM may be the first gong of the death knell of a giant of the software industry. If there is one watchword in this industry that determines success it is FOCUS.