COVID-19 has brought travel to a sudden halt. Airlines need strategies for navigating the crisis and returning to the skies.
Only four months after the first case of COVID-19 was reported in China, the disease has spread worldwide and afflicted well over two million people. To curb the spread of coronavirus, many countries have taken extreme measures, including quarantines and border closures. As of early April 2020, 91 percent of the world’s population lived in countries that limited or forbid the entry of noncitizens and nonresidents.
In addition to the human toll, COVID-19 is devastating the global economy. Although almost every sector feels some repercussions, few have been as hard hit as the airline and travel sector. The sudden, sharp decrease in travel demand is much worse than that seen after September 11, 2001, and the 2008 financial crisis, combined. Airlines had more robust balance sheets when COVID-19 emerged, compared with previous crises, but a slowdown of this magnitude leaves even the strongest players vulnerable.
Most airlines have sufficient short-term liquidity to survive the next three to six months, despite the sudden plunge in revenue. Some airlines have declared bankruptcy, but governments are also stepping up and providing financial support to ensure that airlines remain solvent. But the long-term picture raises concerns. Airlines will not return to normal operations and demand levels until 2022 at the earliest—and when they do, it will be in a world forever altered by COVID-19. That means 2020 will be a balancing act, as airlines simultaneously attempt to stabilize their business while preparing for demand recovery, all while operating in an uncertain landscape where the usual assumptions about traveler behavior may no longer apply.
The end of normal: Current airline demand
With the closure of international borders and imposition of stay-at-home directives, travel demand is almost nonexistent. In the United States alone, travel spending for 2020 is expected to decrease by around $400 billion, translating into a loss of about $900 billion in economic output.2 These numbers mean that COVID-19 would have more than seven times the impact of September 11, 2001, on travel-sector revenues.
Worldwide, airline capacity is down 70 to 80 percent in April 2020, compared to April 2019, and multiple large airlines have temporarily ceased operations. Overall, almost 60 percent of the global fleet was grounded in early April 2020.3 Again, a comparison with previous crises provides some perspective. US airline capacity was down more than 70 percent in early April 2020, compared with April 2019 (Exhibit 1). Those drops far surpass the year-on-year declines of 19 percent after September 11 and 11 percent after the global financial crisis of 2008. Likewise, we estimate US airline load factor is now down about 70 percentage points, well above the drops seen with prior crises.
With fleets grounded or most passenger flights cancelled, airlines are directing their energies to assisting with coronavirus-relief efforts. Many planes that typically fly people now transport cargo, including medical supplies used to fight COVID-19. Some airlines are also providing medical workers with free round-trip flights to New York City and other hard-hit areas, while others are helping by seconding staff into areas that need extra hands, such as medical facilities and grocery stores. These steps are a natural and much-needed first response to the crisis.
Looking ahead: How airline demand might evolve
Of course, everyone hopes that the coronavirus is quickly contained and that a vaccine or effective cure becomes available, but it is also necessary to consider alternatives. Another Aura article, “Safeguarding our lives and our livelihoods: The imperative of our time,” presents nine scenarios that illustrate how the COVID-19 crisis might evolve, depending on the success of containment efforts, government policy, and other factors. When examining how global travel demand might recover, we focused on two of these scenarios: one in which the pandemic resolves relatively quickly and one that takes a more pessimistic view. These divergent scenarios allowed us to envision and plan for two very different outcomes at a time when uncertainty reigns.
Even in the more optimistic scenario, in which the spread of coronavirus is rapidly and effectively controlled, air travel still drops by almost 50 percent in 2020. But, in this scenario, governments create strong economic interventions, travel bans start lifting as COVID-19 cases drop, and the global economy begins recovering in early May. Simultaneously, airlines successfully stimulate demand by lowering ticket prices. People resume their normal behavior, with no lasting differences, and airlines ramp up operations. Global travel returns to pre-crisis levels by 2021 and exceeds them in the following years.
In the more pessimistic scenario, a coronavirus resurgence requires long-term mobility restrictions, economic interventions are weaker, and governments maintain travel bans for longer. As in the more optimistic scenario, airlines cut prices to stimulate demand but see limited gains. For leisure travelers, the combination of economic uncertainty and fear of infection results in low demand. On the business side, some work trips are replaced with the videoconferences that have become the norm during the pandemic. Air travel demand drops by about 60 to 70 percent in 2020 and does not recover to pre-crisis levels until 2023 or even later.
In a holding pattern: Immediate actions required to maintain operations
With revenues plummeting, airlines must ensure that they have sufficient cash on hand to fund their short-term operations. Although many large airlines have enough cash to cover more than six months of zero-capacity operations, others have had to draw on available credit lines that they established pre-crisis. While some are also investigating new loans, for which they would use aircraft, real estate, and other unencumbered assets as collateral, they may have difficulty securing the funding. After all, the value of their assets has dropped sharply as demand contracts. Smaller, regional airlines are especially vulnerable to financial pressures. Widespread ratings agency downgrades could trigger breaches of covenants on debt agreements and increased holdbacks by credit-card issuers, cutting into airline working capital at a critical juncture.
Governments have already stepped in to help airlines sustain liquidity, and several are considering various financial-aid packages for them, including the following:
Direct subsidies, designed to supplement company cash flow, which are generally distributed evenly to all industry participants; these may come with certain conditions, such as the need to maintain employment levels.
Direct financial aid, such as government loans, or guarantees to ensure debt provision from financial institutions; these can have various structures and covenants, such as requirements to have an oversight board, time restrictions, or other limits on corporate governance.
A reduction in, or waivers of, government-controlled taxes or regulations, such as landing fees; these incentives encourage airlines to keep operating, since they cannot collect benefits unless they are active.
The United States has already answered a call for relief from airlines through the Coronavirus Aid, Relief, and Economic Security Act (CARES) stimulus package, which earmarks $50 billion in loans and salary support for passenger airlines. Other countries, including Finland and Norway, have started to extend loans to airlines.
Airlines must ensure that they have sufficient cash on hand to fund their short-term operations.
With government support varying by country, some airlines may receive a competitive advantage and emerge from the crisis stronger than they were in the past, relative to their competitors. For others, of course, the opposite may be true.
Preparing for take off: Next steps for airlines
After airlines have addressed their immediate liquidity issues, they require a plan that guides them through the ongoing coronavirus pandemic and its aftermath. They may find a path forward by following a framework that Aura created to assist companies on their journey to the next normal. It guides companies through five phases: Resolve, Resilience, Return, Reimagine, and Reform. We have identified the questions and issues that companies must consider along this journey, with some being relevant during multiple phases (Exhibit 2).
Resolve and Resilience: Surviving through the crisis
Most airlines are now focused on staying in business and keeping the lights on. But they will benefit their customers and employees much more if they also think strategically during this difficult time and consider challenging questions. Take liquidity issues. Will airlines need to adhere to certain operational requirements, such as continuing certain flight routes, if they accept government assistance? And if they use assets as collateral to improve liquidity now, will that restrict their use in the future? If airlines fail to address such questions until late in the crisis, they might not recognize the long-term consequences until it is too late to reverse course.
With travel at record lows, airlines will also benefit from developing new strategies to connect with customers, who probably are not flying, and employees, who may not be working. And looking ahead to the day when travel restrictions lift, airlines might want to begin thinking about adjusting their health and safety operations now. Passengers may be hesitant to travel even after the coronavirus is contained, believing that airports and planes might expose them to infection, and employees might have similar concerns when returning to work. Many airlines have already adopted new safety protocols, and others are now developing them. Some of the strategies that Chinese airlines have enacted—requiring passengers to wear masks and taking their temperatures pre-flight or asking for registration of previous and planned travel—might be replicated elsewhere.
Return: Ramping up operations
Airlines will experience a gradual and uneven return to operations that requires an unprecedented logistical effort. Done poorly, their strategy may be as costly as the crisis itself. What’s more, airlines must ramp up operations alongside ever-changing health mandates and government guidelines to which they must adhere.
While demand is currently low, airlines can gain an advantage by planning their return to large-scale operations now. It may be difficult to predict when that will occur, so they should carefully monitor early indicators for demand, such as flight-search activity, and examine data to identify customer segment and geographies that may represent new growth pockets.
Consider the Chinese market as an example. Some signs hint at possible demand growth, such as the reopening of many tourist attractions, greater hotel occupancy, and an uptick in public-transport use. A look at ticket sales is concerning, however, since purchases have plateaued after recovering slightly from their nadir. And a close examination of passenger demographics suggests that the current customer base may be very different, with young people and budget travelers predominating. Customer behavior has also changed, with short booking windows—often a week or two—now common as fewer travelers make plans far in advance. Passengers are also mostly booking domestic flights, and international travel is still waiting for its return.
Since travel may take years to reach pre-COVID-19 levels, airlines may have questions about whether they can truly stimulate demand. Although we do not know what new regulations may emerge to govern travel, there could be some time-consuming additional checks or requirements that discourage business or short-term leisure travelers from taking trips. Regulatory differences between regions may also drive costly complexity in operations and create confusion for customers. Airlines will need to work proactively with one another, regulators, and others in the ecosystem to ensure a smooth and consistent customer experience while ensuring safety.
In this environment, airlines should carefully consider whether any specific incentives or discounts will produce the desired results or simply eat into their financials. While marketing efforts will be essential, as always, their content will change to reflect new customer preferences and concerns.
Again looking ahead, airlines may gain an advantage by thinking about the actions that their competitors are likely to take as travel increases and by determining how they will respond. Taking this step now will help them capture their fair market share—always an important goal, even if demand remains low. Airlines can also prepare by considering which people, processes, and systems must be available when operations begin to ramp up, so they can move quickly.
Reimagine and Reform: Becoming stronger than ever
During these stages, airlines must acknowledge that once-dependable patterns may disappear and that the traditional methods for determining prices, flight routes, and passenger incentives may no longer be valid because passenger preferences, demographics, and behavior have shifted. For example, segments that in the past might have been easily lured onto flights with cheap fares and deals might be less responsive to such actions if they still have health concerns. Some governments might also complicate the picture by making unexpected policy changes that restrict travel to or from their countries, even after the pandemic abates. As airlines gather information on these changes, they may need to update their pricing and revenue-management systems because they typically rely on past observations to create forecasts.
In addition to revising their planning processes, airlines may need to adjust the end-to-end customer journey since passengers may have new expectations and behaviors once they begin to travel again. Businesses may be reluctant to have their employees travel, especially internationally, and this may continue for some time. With such changes occurring, airlines may need to update their products, networks, and operations.
Finally, the airline industry itself will be different once the pandemic subsides. Some airlines will be stronger while others will be in a more difficult position than they were previously, or even sidelined altogether. Further consolidation is also likely in the new landscape, as are major strategic changes. With so many changes happening so quickly, and in a time of such disruption, airlines might want to reassess the competitive landscape and abandon any prior assumptions about their rivals before making major decisions.
Almost overnight, airlines saw travel demand evaporate and busy fleets grounded. With revenues plummeting and continued uncertainty about the pandemic’s course, airline leaders may have difficulty looking beyond the next few months. But those that think strategically about managing their return to large-scale operations, reimagining their business, and reforming their organizations to suit the next normal will help both their employees and their customers. Collaboration could be increasingly important to their success in the new world. For instance, airlines could form marketing partnerships with hotels, tourism agencies, and others within the travel ecosystem to increase demand, or assist governments and regulators in creating worldwide or regional standards for hygiene or operations. Such collaborations, as well as other strategic moves, will help airlines resume their primary goal of connecting our world.
The best of our recent research and ideas for investors.Aura on Investing draws on the perspectives and experience of Aura consultants who advise investors, and other sources from around the world. To learn more about our expertise, click link to learn
Are you asking enough from your design leaders?
Companies that excel at design grow revenues and shareholder returns at nearly twice the rate of their industry peers.
The transportation-and-logistics sector is especially susceptible to economic shocks. Here’s how to prepare your operations for a smoother ride.
The transportation-and-logistics (T&L) sector has benefitted from many of the most important business trends of the past half century. Globalization, the evolution of sophisticated just-in-time supply chains, and the rise of e-commerce have all helped the sector grow at a rate broadly similar to the overall economy.
But it hasn’t all been smooth sailing. Economic downturns tend to hit the sector particularly hard. Our analysis of the past five US recessions shows that T&L companies suffer more on average than the economy as a whole (Exhibit 1). And in recent cycles, the problem may have worsened. Truck transportation, for example, experienced little contraction in the recessions of 1980, 1982 and 1991. In 2001, by contrast, the industry shrank by 6 percent, and the 2008 recession triggered an 18 percent contraction.
As in all industries, sector averages don’t tell the whole story. Some companies ride out downturns much more successfully than others. When Aura analyzed the performance of around 1000 large, publicly traded companies through the 2007-2008 global recession, we identified a subgroup of “resilient” organizations that outperformed their peers by a significant margin over the cycle. The performance of these companies dipped less overall during the recession and improved faster during the ensuing economic recovery. By 2017, resilient companies had delivered a cumulative total return to shareholders (TRS) that was more than 150 percent higher than their non-resilient counterparts. Among the logistics and transportation players in the study, the gap was even starker, at 267 percent (Exhibit 2).
A playbook for resilience
What made the difference? Part of the formula is fast decision making, enabled by a well-prepared organization. Our analysis also identified a playbook of specific interventions applied by resilient companies (Exhibit 3). In the lead-up to the recession, these companies took steps to achieve extra financial flexibility. They reduced balance-sheet debt while competitors were piling it on. And when the downturn hit, resilient companies moved faster and further than others, selling off businesses and cutting costs through improvements to operational effectiveness.
That focus on cost and value helped resilient companies maintain their margins—and, even more important, their key customer relationships—through the crisis. It also put them in the best possible position to take advantage of the recovery. As the economy began to pick up, resilient organizations were ready to ramp up in response to growing demand, while also taking the opportunity to acquire new assets from distressed competitors.
Next time will be different
Business cycles are inherently unpredictable. Transport and logistics companies don’t yet know if today’s political and economic uncertainties will be enough to stall the economy, or how deep and how long any resulting slowdown will be.
What is clear, however, is that responding effectively to the next downturn will require a different approach. Getting past the limitations of traditional performance-improvement methodologies oriented around head count and cost will require fresh thinking about boosting productivity.
That’s especially true in the area of operating-cost reduction. In the decade since the 2008 recession, digital technologies have transformed the pressures and opportunities that logistics companies face, driving a significant rise in customer expectations, for example. Used to the speed, flexibility, and transparency offered by the best e-commerce operations, customers increasingly expect similar service levels across the full spectrum of transportation activities.
On the other side of the coin, companies now have new levers to pull in addressing operational costs and efficiencies, thanks to the availability of the Internet of Things (IoT), digital workforce tools, advanced analytics, and machine learning. Today’s leading T&L companies are adopting these approaches to achieve dramatic performance improvements.
The new generation of digital tools can be applied across four broad areas of companies’ operations: their people, their processes, their supply bases, and their networks (Exhibit 4). Let’s look at each in turn.
Manage your people digitally
Improved workforce management is a significant opportunity for T&L companies. The labor-intensive nature of many activities, combined with significant variability in labor demand and skills shortages in key roles, makes recruiting, managing, and retaining staff particularly challenging.
Leading players are now applying data and advanced analytic methods—such as machine learning and artificial intelligence—to a broad range of workforce-management tasks: demand forecasting, capacity planning, recruitment, daily scheduling, and task allocation and performance management. One road-transport company, for example, used a data-driven approach to understand and address the most significant factors that led to high rates of driver attrition. The company started with more than five million data points extracted from employee sentiment surveys, HR, payroll and finance systems, dispatching systems, and on-vehicle computers.
Using this data, the company built multiple models to analyze the factors that had the biggest impact on driver attrition. That work identified five specific clusters of drivers who were much more likely to leave, providing the basis for a number of targeted initiatives designed to address important pain points in the driver experience.
Moreover, models indicated that if the company achieved its attrition-reduction target, overall EBITDA would rise by about 4 percent. More broadly, our analysis suggests that an integrated digital workforce-management transformation—applying a range of different tools and techniques—can unlock 10 to 20 percent of additional value for T&L companies.
Automate and streamline your processes
New digital approaches can transform the performance of core operations as well. The right digital tools boost efficiency by revealing the root causes for transportation-asset failures, thereby reducing the need for high-cost overhauls—and by automating routine activities such as report generation. They improve quality, eliminating the errors that can creep in when managers and frontline personnel rely on email, spreadsheets, or paper documents. And they transform effectiveness, enabling decisions to be made faster, with more relevant, timely, and accurate data.
At one large rail company for example, the reliability of its thousands of locomotives had fallen sharply for years. Managers thought that a more robust, time-based maintenance program and additional overhauls would be an effective answer.
But when the company systematically analyzed seven years of locomotive-failure data, a different picture emerged. The root cause turned out not to be a lack of maintenance, but poor scoping and targeting. Managers fine-tuned more than 80 percent of the required maintenance tasks, saving more than 30,000 hours of maintenance per year thanks to more accurate, time-based maintenance rationalization. Overhaul costs fell by a quarter, generating savings that the company reinvested in new condition-monitoring technology that let it further improve maintenance and asset-replacement decisions.
One large rail company saved more than 30,000 hours of maintenance per year thanks to more accurate, time-based maintenance rationalization.
For a different logistics provider, the problem was a large backlog of maintenance tasks. Pressure on technicians to increase their work rate only compounded the problem by reducing the quality of the repair work that was completed.
The company found that the main root cause was its cumbersome planning process. The task list allocated to technicians was updated only once a week, and they were instructed to complete tasks in the order presented to them. Since that order did not account for the issue’s criticality or the location of the asset, technicians often had to travel significant distances to work on relatively minor jobs, while more important ones waited nearby.
The response was to build a new digital tool that allowed planners to cluster jobs by location, and prioritize tasks according to their likely impact on commercially important service-level agreements. The new approach saved maintenance managers around an hour of planning work a day, while increasing maintenance efficiency by more than 15 percent and reducing service-level misses by more than one-quarter.
The opportunities offered by technology extend beyond the optimization of individual processes. Some leading transportation and logistics companies are now using digital approaches to link their operations from end-to-end, providing significant improvements to visibility, performance and responsiveness.
Engage your supply base
In recent years, logistics and transportation companies have become much smarter about what they buy—and how. Most have developed sophisticated procurement capabilities, such as comprehensive category-management strategies, improved negotiation tactics, and careful spend monitoring.
Building on those fundamental good practices, leading players are now using digital tools to further improve the efficiency and effectiveness of their purchasing activities. They’re applying advanced analytics to understand the dynamics of their demand and the characteristics of the market, automating routine transactional activities across the source-to-pay process, and building integrated procurement platforms to enhance spend transparency.
One global logistics company recently used e-procurement tools to carry out two large tenders. One, for rail, covered 50 providers and roughly 5,000 origin and destination pairs for different container types and directions. The second, for truck services, covered 750 vendors and 12,000 lanes. Using a digital approach allowed the company to address more than a million data points across the two tenders, eventually unlocking additional price reductions of 5 percent for rail and roughly 10 percent for trucking.
Another large transportation company used a range of digital spend-management tools to capture savings of 20 to 30 percent in one of its most significant spend categories: tires. For more than a decade, the company had sourced new and retread tires from a single supplier, while leaving procurement of services such as tire repair and installation to the discretion of individual field locations. That approach meant no price competition for tire purchases, and no scale or consistency in tire services.
The company started from a clean sheet, defining a standard set of tire specifications depending on asset type, operating conditions, and tier positions. It then used advanced e-sourcing tools to generate request-for-proposals from numerous manufacturers. On the services side, the company applied digital mapping tools to analyze the networks of potential dealers, with the aim of identifying opportunities to consolidate purchasing from a smaller number of providers.
Reimagine your network
Network optimization is fundamentally difficult. As they develop their networks, T&L companies face a multitude of complex, interdependent decisions, which must be made with incomplete data and for uncertain future demand.
Today, the development of powerful modeling, simulation, and analytics approaches is changing the way companies tackle complex network-optimization problems. The latest tools deliver deeper insights into not only the current performance of a network, but also its future performance—allowing organizations to identify bottlenecks, evaluate multiple alternative configurations, and rapidly stress-test their designs against a wide range of scenarios.
A shipping line looked at three potential changes to its network: adjustment of feeder connections, review of port calls with low yield, and replacement of expensive transshipment cargo with more attractive alternative cargo. Leveraging advanced analytics, it simulated the expected revenue loss, cost savings, and potential revenue-recovery probabilities for each possible intervention across all ship systems and cargo flows.
The project revealed opportunities to simplify the shipping line’s network and capture several million dollars in annual savings. To identify inefficient repositioning of empty containers, the line applied an algorithm that examined patterns in several million container movements. That project improved the steering of tens of thousands of containers across all geographies. Inspired by the results, managers throughout the company now use the tools developed for these analyses in regular reviews, driving continuous savings and performance improvements.
Another company, this time in the rail sector, used a simulation-based approach to optimize the long-term planning of its maintenance network. The company modeled the changing characteristics of its fleet over a ten-year time frame to understand future demand for critical maintenance resources. In only two months, that effort allowed the company to reduce its planned capital expenditure on maintenance facilities by about $100 million.
Transformation, not intervention
The approaches described in this article are already being applied at transportation and logistics companies around the world. On their own, however, advanced digital tools are not enough to deliver real impact. Translating opportunities into value requires companies to make coordinated changes across their people, technology, processes, and culture—the type of systematic, large-scale transformation that involves a major commitment from leaders.
It won’t be easy. But when is the right time to take the first steps? Right now. Nobody knows when the next downcycle will hit, how long it will last, or how deep it will go. As history has shown, however, the companies that prepare best for difficult times emerge strongest from them.
Powerful trends that have disrupted industries around the world are now affecting industrial distributors. A few are quickly building scale, making advances in commercial and operational excellence, and digitizing to create the seamless, omnichannel experiences that customers now demand. But we expect slower-moving distributors to struggle—and some to go the way of Blockbuster and Borders.
We also expect the disruption to accelerate. Fast-moving digital players eyeing the industry’s trillion-dollar revenue pools are offering best-in-class customer convenience and more price transparency. Sophisticated customers, armed with new data, are demanding deeper discounts and better promotions on more commoditized products. As manufacturers and customers gain leverage through consolidation, some are forging strong relationships that leave distributors in the cold.
These and other challenges come at a difficult time for the industry, whose returns have lagged those of the overall industrials sector for 15 years. Margins have remained narrow even in the recent economic recovery, and the pressure may rise. We expect many industrial distributors to lose strong customer relationships in the next few years and become mere links in supply chains, rather than business partners who add value.
But while the overall picture may look bleak, we see opportunities across sectors. A handful of leaders are growing share and margin. Based on our research and experience serving clients across industries, we believe that distributors who move quickly can create deeper customer relationships and sustainable competitive advantages to outperform consistently in the years ahead.
In this brief article, we review the industry’s major challenges and then outline the five strategies that we believe will help the winners outperform in the next decade.
The business is getting tougher
Based on our research, experience, and discussions with industry executives, we’ve identified a combination of market trends and internal challenges that threaten revenue growth and profitability in wholesale distribution.
Suppliers are aiming to build relationships directly with end customers
As manufacturers search for ways to increase margins, some are eyeing the profit pools of distributors. The rise of new digital technologies makes it easier than ever for manufacturers to pursue the idea at scale.
Some manufacturers are building their own distribution channels. For example, Bridgestone and Goodyear, two of the largest tire manufacturers, announced a joint distribution partnership in 2018. The new venture, TireHub, complements the companies’ networks of third-party distributors and provides a fully integrated distribution, warehousing, sales, and delivery solution, competing directly with traditional tire distributors.
Other manufacturers are selling directly to consumers on online platforms. For example, Dow Corning recaptured cost-sensitive customers by establishing Xiameter, a low-cost web-based brand. Within ten years of launch, online sales accounted for 40 percent of Dow Corning’s revenues. Kohler, a major manufacturer of plumbing products, has invested in direct-to-consumer and builders’ channels with a state-of-the-art e-commerce platform and supporting organization structure despite an extensive network of distributors and retailers who sell its products. The list goes on: prominent manufacturers across industries are looking for ways to capture a larger share of the overall value chain.
Disintermediation seems poised to accelerate. According to our 2018 survey of more than 100 senior manufacturing executives across the United States, manufacturers predict that the overall share of direct-to-customer sales will increase slightly in the coming years and that the share of products flowing via distributors and retailer channels will fall modestly.
According to a senior leader at a midsize HVAC manufacturer, “Direct dialogue with customers is a more harmonious sales model.” A department head at a midsize general industrial firm agreed. “We save money working directly with consumers,” he explained, “so we’d like to take care of distribution ourselves.”
These themes echo across segments (Exhibit 1). Manufacturers aiming for more direct end-customer sales say they are developing more end-customer relationships (40 percent of survey respondents), easing customer accessibility on the web (21 percent), and aiming to capture distributors’ margins (14 percent).
Customer expectations are rising
Professional buyers who shop on Amazon now expect digitally enabled services such as customized reporting, multichannel ordering, and full visibility into distributors’ inventory. Among customers who responded to our survey, 57 percent said omnichannel convenience was one of the top three improvements distributors should provide. Features they want include 24/7 customer service, a complete e-commerce website, order tracking, and real-time inventory management. Customers expect to make 30 percent more of their purchases from distributors via online means; those in the electrical segment expect a 50 percent increase.
Our interviews with industry players confirmed the vital importance of value-added services. “I’m really worried about the labor shortage and our inability to build houses fast enough to meet demand,” said a local buyer at a national homebuilder. “A distributor who installs windows and doors will win my business day in and day out.” The chief of manufacturing engineering at a global auto parts manufacturer explained that his distributors “have always managed inventory for us—and that gives us peace of mind.”
Disruptive new entrants are accelerating competition
New entrants are encroaching on distributors’ territory, disrupting the status quo, and accelerating the competitive intensity. Digital leaders with top-shelf talent and deep pockets, including Amazon and eBay, pose the greatest threats. By entering the B2B space, Amazon Business threatens to cut many distribution players out of the supply chain. Its integrated procurement system features multiuser accounts, flexible payment options, and enhanced invoicing capability. More than 100,000 business sellers now offer more than 400 million SKUs on the platform, serving a total of 300,000 business customers. If its growth continues, Amazon Business could approach $20 billion in sales around 2020.
Experts tell us that in deciding whether to enter an industry, digital giants like Amazon consider how much they can improve customer experience with their current capabilities and infrastructure. The distributors at the greatest risk may therefore be those operating in large segments with high margins, limited technical expertise, low value-added services, low customer purchasing power, and easy-to-ship products (Exhibit 2).
Electronics, general industrial, and auto parts may therefore face the largest disruption risk. Electronics, even with a low EBITA margin of 2.8 percent, is the largest target, with $354 billion in revenues in the United States alone.
All is not lost, however: distributors still have some advantages over other digital players. Customers tell us that distributors have the upper hand across several top selection criteria, for example. And while many distributors rightly fear Amazon and other digital attackers, top distributors are aggressively expanding their “moats”—including deep product knowledge, technical expertise, service capabilities, and a long tail of products that pure digital players can’t match without big investments in technical talent and physical assets.
Competitive threats are not confined to digital entrants. Big-box retailers are also challenging traditional distributors, using their analytical prowess and customer insights to create tailored value propositions for contractors, for example, and using their large footprints to offer in-store convenience and extended hours.
Innovative technologies are disrupting traditional business models
New entrants are encroaching on distributors’ territory, disrupting the status quo and accelerating the competitive landscape. New data and advances in computing power, data storage, analytics, and mobile platforms are turning industries as varied as music and healthcare upside down. Wholesale distribution is not immune, of course. Predictive and prescriptive analytics are helping the most sophisticated customers and manufacturers use dynamic pricing, predict churn, and optimize workforces and capital. For instance, UPS reports that its new navigation system saves its drivers about 100 million miles and 10 million gallons of fuel each year, reducing logistics costs by $300 million to $400 million.
Automated warehouses are speeding deliveries while cutting labor costs. Robots can now handle every step of the warehousing process, from unloading to quality control, reducing order-picking labor costs by as much as 80 percent and boosting operational efficiency in industries with razor-thin margins.
Autonomous vehicles are on the horizon—a potential boon to the distributors who can afford to put self-driving fleets on the road. Nearly every leading distributor tells us that transportation costs are affecting their margins. Flatbed trucking rates have risen 40 percent since 2016. Experienced drivers and high-quality warehouse workers are hard to find—and to keep.
A senior executive at a leading North American building products distributor put it plainly. “The labor issue keeps me up at night,” he said. “We’ve paid millions in raises just to keep our people from accepting other jobs. This is especially true in our driver’s pool. We want to use technology to optimize our need for labor, especially in a world where it is increasingly difficult to fill positions.”
Tomorrow’s leaders are building five advantages today
Winning distributors are already adapting to the major trends in the market. Based on our research and experience, we’ve identified five transformative actions that will distinguish the industry’s outperformers across segments.
1. Build scale where it matters most
Scale will continue to be a key to margins. It helps distributors gain purchasing power, create denser delivery routes, optimize warehouse locations, increase coverage of products and sales, and reduce redundancies. These and other synergies can expand margins by up to 3 to 4 percent return on sales in some mergers with significant overlap.
Top distributors have been pulling this lever for decades and are going after larger targets or merging with other top distributors. Since the bottom of the recession, M&A activity for the large publicly traded distributors has increased: 27 percent of top distributors have acquired at least one other distributor, up from 20 percent in the decade before the recession, and the average acquisition today is roughly 35 percent larger.
Substantial rewards can come relatively quickly. For example, a building product distributor nearly doubled its combined-entity earnings before interest, taxes, depreciation, and amortization (EBITDA) within two years of an acquisition by pursuing procurement synergies. It consolidated suppliers in key categories; eliminated redundancies in finance, IT, HR, and back-office support; consolidated overlapping locations; and designed denser routes.
The keys to the margin improvement included an engaged leadership team, well-resourced integration office and functional teams, a rigorous cadence, and careful performance management. Many acquisitions fall short of expectations, of course. Some distributors have left tens of millions of dollars on the table because of poor planning, a lack of sales integration, limited leadership and resource commitment to the transformation, or underestimates of cultural and technological integration challenges.
Some companies also see diminishing returns as they keep building scale even after reaching number one or number two in a marketplace. For many large distributors, especially those who have reached the sweet spot of scale in their key markets, a better long-term bet is to invest in commercial and operational capabilities that they may have neglected as they scrambled to build share and integrate disparate pieces of the business.
2. Compete smarter
With countless customer-SKU combinations and constant margin pressure from manufacturers on one end and customers on the other, distribution is ultimately a low-margin business. Even the most profitable sectors such as general industrials and auto parts achieve only single-digit EBITDA margins. Leaders must therefore improve relentlessly in sales-force effectiveness, pricing, category management, and fleet operations.
Some leaders are looking beyond M&A, using new treasure troves of data and strides in advanced analytics to unlock commercial opportunities. They’re shifting away from their traditional role of “cost-plus” or discount providers, building best-in-class commercial organizations to strengthen customer pull and differentiate their products and services.
The best distributors equip sales staff to act as business partners who can identify customer pain points and co-create business solutions.1 For example, a leading distributor launched an initiative to shift its customers to a higher-margin mix of products. To get the sales force on board and help them execute, the company trained them on best practices in selling solutions. It invested in routines, processes, and tools to support frontline sales managers: a comprehensive sales playbook, ongoing training, and a sophisticated customer-relationship management system that provides product and pricing recommendations directly to the sales force.
Some distributors have not yet embraced the latest digital tools or dynamic pricing but have begun their journeys of commercial excellence. They are building pricing organizations to drive consistent pricing processes; crafting escalation and exception processes; implementing tight controls and best practices for contract setting, rebates, and payment terms; and building sales-force capabilities in value selling and negotiation. For most distributors, these changes represent a significant shift from traditional selling practices and oversight of highly entrepreneurial sales forces. But we are seeing that nearly every distributor who increases pricing discipline and sophistication has expanded margins and helped sales reps focus on what they do best: building and maintaining relationships with customers.
We’re not alone in seeing commercial excellence as a pillar of success in the industry, of course: 60 percent of leading publicly traded distributors mentioned it in their latest annual reports.
3. Become leaner and execute flawlessly
Many large distributors still act like decentralized local businesses without consistent processes, routines, or performance management. The rapidly changing landscape is finally pushing many to reconsider investments in core operations to capture incremental efficiencies: the annual reports of around 50 percent of the largest distributors mentioned the need to improve operational capabilities.
Most distributors can make significant progress in several areas. For example, smart, data-driven product purchasing and sourcing are helping leading distributors shape categories to optimize both their own and their customers’ P&Ls. They undertake thorough category reviews to understand improvement opportunities, regularly refine and streamline their assortments based on customer and competitive insights, and conduct fact-based negotiations with manufacturers for volume discounts and better pricing. Many are now using data-driven purchasing and supply management—for example, by standardizing specifications and using clean-sheeting and other sophisticated purchasing techniques.
Some are establishing more robust vehicle maintenance programs and making better replace-or-repair trade-offs based on total cost of ownership over an asset’s life. Taken together, these improvements can reduce fleet-related costs by 10 percent or more, raise asset availability, and improve customer and employee satisfaction. A senior executive at a European packaging distributor, asked to describe a best-in-class distributor, talked about “tremendous cost management and flawless execution.”
A final area of improvement involves streamlining administrative and overhead functions to reduce cost and improve effectiveness. While most distributors are already lean, we often see opportunities to consolidate functions such as accounts payable, purchasing, HR, and IT that have become widely dispersed throughout the organization as a result of continual M&A activity.4 Some distributors are also adopting robotic process automation that can free resources now devoted to repetitive tasks such as invoice matching, processing expense approval requests, and auditing reported hours versus schedule (a common pain point in warehouse operations).
4. Move beyond product distribution
Most wholesale distributors who have reached scale do much more than product distribution: they’re core value chain partners who provide customers with a suite of value-added services such as credit financing, inventory management, and product expertise. In surveys and interviews, customers tell us that these traditional value-added services are now becoming table stakes.
With that in mind, a few leading distributors are taking a customer-back view of their customers’ challenges and pain points, partnering with them in new ways to raise satisfaction, such as by installing windows and doors for the many custom home builders struggling to find qualified labor. Some are improving customers’ margins—for example, by offering international sourcing and providing high-end packaging solutions.
Tech-enabled transformation: The trillion-dollar opportunity for industrials
Many distribution leaders tell us that building differentiated value-added services that address customer pain points can help them fend off challenges from traditional and online competitors alike. An automotive distribution company is making significant investments in value-added services, for example, to provide incremental value to customers—especially those willing to pay a premium. Many distributors can use their superior product knowledge and technical expertise to provide clear customer value, maintain premium pricing, and create a moat against pure digital players.
5. Embrace the digital revolution
As noted, digital advances are game changers in the distribution industry. But most distributors are still in the early innings of digital adoption and lag other logistics industries, despite customer demands for more convenient omnichannel experiences. In fact, our digital survey of more than 1,000 business purchasers found that over 90 percent of B2B buyers conduct research online before making a purchase, and 84 percent prefer to make repeat purchases through online channels,6 given their convenience, cross-channel services, and features.
We believe every distributor needs a clear digital strategy. Digitizing the go-to-market model, the typical first step, means redesigning key customer journeys, offering a cohesive and integrated omnichannel experience (website, mobile app, in-store location, and social media), simple credit applications, paperwork integration software, and a coherent online portal to track orders. Developing a rich data ecosystem with robust analytical tools can give distributors and their sales teams a 360-degree view of customers, which can drive targeted product recommendations and service decisions.
Some distributors are building novel, customer-first digital flows that reimagine the typical “stock and flow” distribution model to better reflect how customers operate. For example, instead of requiring contractors to visit a location each morning to pick up supplies for that day’s work, digital buy flows can ingest bills of material to help customers forecast purchases and consolidate a single weekly delivery. This saves restocking costs for the distributor and time and money for customers. Distributors with the talent and imagination to reengineer their business models will differentiate themselves from the competition and generate outsize value for customers and shareholders alike.
Distributors investing in digital and e-commerce strategies are accelerating sales growth, expanding customer reach, and improving customer retention and loyalty. Grainger has led the pack, creating three e-commerce platforms—Gamut, Grainger, and Zoro—to reach different types of customers. The company’s dedicated digital team has also built analytics-based personalization and real-time inventory updates. These investments have consolidated Grainger’s spot as a leading distributor in digitally enabled operations, with e-commerce generating 51 percent of revenue in 2017 (up from 25 percent in 2012).
The first step
As times get tougher, many distributors are wondering if they can move fast enough in the right direction to fend off digital attackers. Indeed, we believe incremental improvements and “wait and see” attitudes could lead to ruin. That’s why we’re urging our distribution clients to set a bold strategy to reach the ultimate destination: a winning platform.
The race is on. We expect distribution as a whole to follow a version of the Amazon model, with just two or three winning platforms per segment. The laggards—perhaps the majority of distributors—will struggle. Many will become commodity distributors, low-margin logistics providers on someone else’s platform.
The first step is to take a dispassionate, independent view of one’s business to understand the full improvement potential, taking into account what leading players are doing. In our experience, genuine progress requires a structured and transformative approach that is clearly separate from business as usual, with exhaustive assessments and challenges to current assumptions. We believe proactive distributors have levers to adapt and win in the new landscape—but the clock is ticking.
Here are some ways that cities and rail operators can shape the mobility system to incorporate new technologies.
In 2017, the mayor of Nashville, Tennessee, proposed spending up to $9 billion on a mass-transit system, including 26 miles of light rail. Voters rejected the plan the following year. One reason for this outcome: people questioned whether it made sense to spend big money, for decades, on traditional transit when mobility technologies were changing so quickly.
Nashville is hardly the only city where people ask such questions. Even so, investment in light-rail and metro systems is massive. By 2025, we estimate, cities and rail operators will spend nearly $100 billion on new rolling stock.2 Over that same period, we estimate they will break ground on at least $1.4 trillion in new light-rail and metro projects (Exhibit 1). Asia accounts for two-thirds of the spending on construction: for example, Beijing, Kuala Lumpur, Shenzhen, and Singapore are all building at least one rail project with a value of more than $5 billion.
The case for building new rail is strong. The main attraction is enormous efficiency. By 2050, an additional 2.5 billion people will be living in cities, and rail can move more people than any other kind of transportation. Today, one metro line can carry more than 70 times as many passengers as a city street with cars. In the future, a new metro line would carry more than 12 times as many, even if vehicles were shared, smaller, and swift (Exhibit 2).
Rail has other advantages too. If it is electrified, it emits neither greenhouse gases (such as carbon dioxide) nor smog-causing pollutants (such as nitrous oxide or sulfur dioxide). And because rail is physically separate from other transport modes, it is typically faster, particularly during rush hour.
There is, however, a disadvantage to rail projects: they are expensive and take a long time to complete. Successful planning therefore requires looking into the future—even though no one knows how the global mobility system is going to evolve.
New modes of transport are changing how people get around. “Micromobility” in the form of electric scooters and shared bicycles, for example, can convert a 30-minute walk into a ten-minute ride. And change can happen fast; consider how quickly people took to using their smartphones to hail cars. In the future, self-driving taxis (or “robotaxis”) could offer people the convenience of e-hailing at a price similar to the cost of driving their own cars.
Such technologies could take passenger traffic away from rail. A recent survey by the Aura Center for Future Mobility found that 35 percent of Europe’s e-hailing passengers and 20 percent of those in the United States had switched from rail.5 Depending on how robotaxis are regulated, they could put another dent in rail ridership as travelers choose door-to-door options.
If a significant share of passengers gave up rail, operators would feel the consequences. In New York, for example, the competition from e-hailing, together with other factors (such as poor service levels), caused the city to lower its forecast for subway ridership by nearly 10 percent from 2015–19 and has cost hundreds of millions of dollars in lost revenue.7 Such declines might force operators to increase fares or decrease service, driving away even more passengers and worsening street congestion.
On the other hand, new technologies could also help rail attract more passengers by making it easier for people to take transit: for example, in April 2018, Didi Chuxing, the Beijing-based e-hailing–transport-services giant, with a platform of some 550 million users, announced a new function that supplies public-transportation options in combination with its ridesharing services. Lyft is running pilots with cities in California, Colorado, and Florida to provide subsidized first–last mile connections to transit stops.8 Many similar projects are under way around the world.
So it’s complicated. Operators and city leaders need to consider the impact of new technologies and to figure out how they can be integrated into mobility planning—an issue that came up in Nashville. But this does not appear to be happening. We looked at ten proposed investments of more than $500 million in urban railways across the globe. Of these, only one even mentions the possible effects of autonomous vehicles on transit ridership.
Moving beyond uncertainty: How to shape the system
The next few decades will be pivotal. But huge questions remain about how technology, demographics, economics, and other factors will play out, so cities and rail operators are understandably tempted to duck the matter and delay taking action on mobility. If they do, however, they may find themselves playing an expensive game of catch-up to build infrastructure that works in concert with new technologies. By 2030, according to previous Aura research, forms of transport that don’t currently exist could serve as much as 40 percent of today’s transportation-revenue pool.
The idea of “seamless mobility” offers a future vision that can guide action now. Aura, which has written several reports exploring this topic,11 defines seamless mobility as systems incorporating the use of different kinds of transit and enabled by technologies such as intelligent traffic systems and advanced rail signaling. Seamless mobility makes transportation systems cleaner, cheaper, more accessible, and more convenient than they are today.12 In addition, infrastructure would be used with greater efficiency, accommodating a 30 percent increase in traffic while cutting travel times by 10 percent.
Although the specifics will vary from place to place, the following four steps can help cities and rail operators work together to shape systems toward seamless mobility.
To get started, stakeholders need to agree on where they are going. Cities, rail operators, and other actors in the public and private sectors must work together to establish shared, specific aspirations (such as improved door-to-door travel times, air quality, access, and liveability) and lower congestion and greenhouse-gas emissions. Hamburg, Germany, for example, plans to have some kind of public-transportation option within five minutes of anywhere in the city by 2029.14 To meet that goal, dense cities will generally have to use sharing and mass transit more extensively. Suburbs and spread-out cities could incorporate a high degree of private transit, such as cars—preferably electrified (via renewable sources) and autonomous. Remote areas could use on-demand services.
Build a master plan based on a ‘digital twin’
To meet their aspirations, cities and rail operators need to understand how evolving demand and technologies could affect a system’s operations. One approach is to create a digital twin of the mobility system. This would combine new geospatial-modeling techniques with publicly available data to simulate how millions of commuters would reconsider their choices as transit systems change.
This kind of modeling can form the basis of a master plan for an entire mobility system, not just transit networks. Such a plan could include a coordinated set of complementary investments and policy changes: a new rail line, for example, could become more attractive if housing were developed near its stations. Congestion pricing might be more successful coupled with investments in convenient, accessible, and fast public transport. Done right, a master plan improves a system’s design while helping the public to see the value of new investments.
Decide how to enhance and expand infrastructure
Cities differ among themselves, so different places will make different choices, depending in particular on population density and expected population growth.
In sprawling, slow-growing cities—think of Cleveland, Ohio, or Birmingham, England15 —it might make more sense to invest in road-based technologies (such as bus rapid transit or, eventually, autonomous shuttles) than to build new rail and metro lines. This is a rule of thumb, however, not a scientific principle; specific circumstances might point to a different decision. Los Angeles, for example, wants to make its downtown denser and to ease congestion, so it is investing in new rail to achieve both goals.
In dense, slow-growing cities, such as New York or Hong Kong, by contrast, rail is likely to continue to be essential for urban-mobility systems. As long as that holds true, cities and rail operators must invest in them to maintain quality and to compete as other kinds of mobility emerge.
Finally, in dense, fast-growing cities, such as Abu Dhabi or Ho Chi Minh City, urban rail systems will need to expand, since they move people faster and more efficiently than any other form of ground transit.
In every case, cities should train their focus on projects that can adapt as technology evolves. One way is to design projects flexibly; for example, rail stations that connect with autonomous-shuttle services and offer space for bikes or e-scooters can help to manage uncertainty. Another is to redesign contracts in a way that reduces risks to cities. Design–build–operate–maintain agreements, for example, can link ridership with payments to third parties: if fewer passengers use the system, the city pays less. And instead of placing bulk orders to replace rolling stock, rail operators could consider spreading out their acquisitions, reserving the right to cancel or to change specifications along the way.
Establish partnerships with mobility operators
New mobility options are already becoming a bigger part of the transportation fabric, from bicycle-sharing docks at train stations to e-hailing vehicles that provide access to places traditional bus services do not reach. Partnerships with these and other entities can help transit operators to gather data and position themselves for the future.
One possibility is to create a single interface that passengers can use to plan and pay for their trips, whether by rail, bus, e-hailing, scooters, or shared bicycles. Such “mobility as a service” offerings would make the companies that developed them the gateway to the entire system. This role would allow cities or rail operators to continue influencing the mobility system as it evolves.
New kinds of transport and technology are injecting unprecedented uncertainty into mobility planning. Some broad trends, however, can be predicted with reasonable confidence. Among them:
Passengers will behave in new ways and have new expectations.
Companies will base new offerings on innovation and regulation.
New developments will reshape the physical character of some cities.
We believe that cities can respond to these trends and achieve equitable access to transit, fast com-mutes, low emissions, and pleasant streets. This is a tall order. But recall that in the late 1800s, residents of cities were just as worried about the environmental and health consequences of horse-dominated traffic.17 Technology and innovation, in the form of the car and the rail system, dealt with that problem.
By looking forward, cities and rail operators can create a mobility system that meets the current challenge—and serves the passengers not only of this century but also the next.