Disties and the Hard Road Ahead

When we talk about semis we usually talk about the biggest companies in the space (Qualcomm, Intel, Nvidia, etc. ) selling to their big customers (Apple, AWS, Dell). But the industry is much more diverse than that. As with any other industry selling physical products, semis has multiple layers in between producers and consumers, not to mention plenty of mid sized suppliers fulfilling all sorts of less-glamorous but still important sub-segments of the market. In these times of shortage and constraints it is worth taking a moment to think about how chips actually get from production to customers – the Channel.

When large semis companies sell to other large companies, they typically sell directly. But in many (if not most) cases sales are not direct. This gap is filled by a variety of entities, which we usually lump together and call Distributors (Disty to their friends). These can range from massive companies that do hardware manufacturing like ODM Foxconn to small “boutique” firms that target specific pockets of end-customers (and who would universally hate being called boutiques).

Like middlemen everywhere throughout all of history, the disties do not get much respect. Almost to a firm, they will all go out of their way to disclaim that they are not “distributors”, they call themselves ODMs, systems integrators, value-added resellers, channel partners – the list goes on. In fairness, there is a huge range of capabilities here.

We tend to look at the Channel as being comprised of three types of distributors. The pure-play wholesalers, like DigiKey, who are in business to manage their catalog and inventory. The contract manufacturers and ODMs, who tend towards turnkey projects – everything from design to sourcing through to manufacture, and the value-added distributors who typically focus on one end-market niche, or a particular set of customers. These are all very different businesses ranging from massive to Mom & Pop, each providing a different type of value to the market.

Let’s make this a bit more tangible with a hypothetical example. Let’s say you want to build a small electronic device – the flux resistor. You estimate the market for the flux is about 1 million units, and you could sell this device for $100 each, which means the total cost of the device has to be below ~$50 for this to be profitable for you. You pick your favorite hardware designer who draws a schematic and identifies the chips you need for the flux. These chips cost a total of $30, add in $20 for the case and assembly, and to get your $50 bill of materials (BOM).

Most hardware designers will work with you to fully understand what you need the flux to do, and then specify which versions of the chips you should buy. You want to build 20 prototypes. At this scale, you are a small customer, so most chip companies will not give you the time of day. To procure the chips for the samples, you will need to buy them from a low-support distributor, DigiKey for example lists all your parts. You then want to produce 200 samples to let potential customers test the flux out. At this point, DigiKey only has 100 units of the chips, so you have to source around further down the list of disties. If you live in Shenzhen, you can go to Huaqiang Bei Lu and buy them in the mall (as in the picture at the top). The distributors are doing just that – essentially retail level chip sales.

But now you want to take the chip to production. In some cases, for a million units, you can buy from the chip companies direct, but chances are you do not want to buy all the chips at once (aka $30 million). You would rather, break it up in batches. At this point, you probably have to work with some larger distributor who maintains an inventory of chips and is willing to dole them out to meet your staged production schedule. In reality, there is a good chance you would actually start with one of these companies – an ODM or contract manufacturer who supplies the design and procurement of parts. There a dozen or so of these companies in the US and probably a few hundred in Shenzhen. There are pros and cons to working with these companies. Their incentives are not totally aligned with yours. They will produce 1 million units, but quality and design guarantees need to be ironed out with really strong contracts, doubly complicated if you are sourcing from China. But all of this is better than trying to scrounge the parts together on your own. Maybe.

And this is where conditions have really changed during the pandemic. Prior to the current shortages, being a distributor was a rough business. Heavy sales and service requirements plus lots of competition all led to very tight margins. That’s why there are so many small shops, because there are limited benefits of scale here, small shops run essentially as lifestyle businesses for the team and can compete with publicly listed companies. During the slowdown however distributors have, for once, gotten a bit of leverage. Chip companies supply their biggest customers first, with any leftovers going to larger buyers next, and often these are distributors. The distributors then get to play ticket scalpers outside the Super Bowl. True, the prices they pay to the chip companies have gone up, but they can pass the costs and more on to customers who are desperate for any parts. Since lead times for all parts have gone way up, there are a lot of small companies running out of time. You have spent a lot of money designing the flux, and if you cannot get any parts the whole project fails. Better to sacrifice some margin and pay $40 for the $30 chips you need. It’s not quite a bidding war or auction, but any bit of supply the distributors can get their hands on is more than small companies can source directly. And we can see this in the results of many of the public distributors, with some of their first margin expansion in years (but still very small relative to the rest of the industry).

Like so much else in semis right now, these good times will not last indefinitely. The big chip companies have very mixed feelings about their Channel. Some are heavily dependent on them, others treat them as a necessary evil, and some ignore distributors entirely. That being said, their role in leveling out the bumps in the supply chain is always going to be needed.

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