Envisioning a Future Without Transactional Partners

Channel consolidation is causing partners to think more about their valuations. Consequently, they’re dropping transactional, low-margin products to bolster their bottom lines, and that has consequences for vendors.

By Larry Walsh

The background din of channel chatter is dominated by the topic of channel consolidation. If you read posts by our friend Joe Panettieri at ChannelE2E, you know channel consolidation is rampant and accelerating, with channel partners announcing mergers or acquisitions at a rate of three to five a day.

Channel consolidation isn’t new. We’ve been tracking channel M&A for several years and estimate the annual consolidation rate is about 1 to 3 percent the total channel population. In other words, about 4,000 channel partners exit the market annually through consolidation.

While consolidation is on the tip of everyone’s tongues, a more daunting issue faces the channel: the end of transactional resellers. And guess what? It’s related to the consolidation trend.

One of the underlying channel premises is that partners shouldn’t make money solely on selling vendor products. Vendors should – and do – compensate partners through margins and incentives for selling their products. However, the real money is in what partners can do for the customer before and after the sale – the value-add business. Through professional services, partners can make substantial money on their expertise, skills, and service capacity. Remember, that’s the origin of the “value-added reseller” moniker.

In the mid-2000s, the average partner’s revenue was somewhere around 50 percent from hardware and software sales and 50 percent from value-added services, with the majority of the services being pre- and post-sales professional services. Today, according to 2112’s annual Channel Forecast report, services – inclusive of professional, cloud, and managed – make up 68 percent of the average partner’s gross revenue; partners earn just 20 percent from hardware sales and 13 percent from software.

Hardware and software sales, as a percentage of gross revenue, continue to fall each year. In 2017, hardware revenue fell 5 percent and software dropped 2 percent from 2016. Conversely, cloud services revenue jumped 10 percent.

Composition of Average Partner Gross Revenue by Product

The reason for the shift is clear: Services hold more value to partners than products. Vendors’ products are a means to an end. Many early adopters of managed services discovered this fact: If you make money on the services you deliver, you don’t need to touch the product.

The evidence is clear on this point: Services are not just more profitable for partners; they’re substantially more profitable. In the 2112 Channel Forecast study, 66% percent of partners reported their professional services carried margins of 30 percent or higher. Only 3 percent said the same for hardware products. In fact, no partner reported hardware margins greater than 40 percent, whereas 38 percent of partners said professional services generated margins of more than 51 percent.

Composition of Average Partner Gross Revenue by Product

Services profitability is related to channel consolidation because of the margin situation. When assessing the value of a business, the respective margins of revenue sources aren’t looked at in isolation. Instead, the buyer looks at the blended profitability of the overall business. Selling low-margin hardware and software products drags down business profitability, dampening the overall valuation. Therefore, many partners are abandoning transactional product sales in favor of services; they’re looking to bolster their valuations.

Without hardware and the pass-through costs on their books, partners see their valuations substantially improve, making them look more attractive to potential suitors. Even partners that have no intention of selling like the idea of services-only ledgers. They generate more profits, are able to invest more in their businesses, and are more agile in responding to the competition and changing market dynamics.

Many vendors recognize the changing landscape. They, too, see the declining value of transactional product sales, which is why they’re also moving to services-based sales models even for hardware. But the transactional model isn’t going away anytime soon. Vendors need to develop new models and systems for balancing the legacy and declining transactional model against the emerging services-led model to ensure minimal disruption to revenue streams.

The transition from transactional to services-led sales and channel models will open new, more cost-effective routes to market, provide vendors and partners with an opportunity to generate greater value to customers through their expertise and resource capacities, and probably result in better systems that create value for customers.

Here’s the bottom line: Don’t worry about the consolidation trend; worry about navigating the shifting business models.

Larry Walsh, The 2112 Group

Larry Walsh is the founder, CEO and chief analyst of The 2112 Group. Follow him on social media channels: Twitter, Facebook, LinkedIn.