Frank Voisin is the author of the popular value focused website Frankly Speaking, found at http://www.FrankVoisin.com
A recurring theme on this site has been the significant risks associated with investing in companies whose revenues are highly concentrated among a small number of customers. I have never written a post directly addressing this subject, but I have received a few emails over the years that lead me to believe I should. These emails suggest that my wholesale avoidance of companies with highly concentrated revenues is misguided, and the argument seems to boil down to this:
Voss Capital is betting on a housing market boom
The Voss Value Fund was up 4.09% net for the second quarter, while the Voss Value Offshore Fund was up 3.93%. The Russell 2000 returned 25.42%, the Russell 2000 Value returned 18.24%, and the S&P 500 gained 20.54%. In July, the funds did much better with a return of 15.25% for the Voss Value Fund Read More
Fewer customers allows for more focus and better service, which translates into a closer relationship and more stable revenues. These revenues are also lower cost to the company than would otherwise be the case where there would be significant costs associated with finding and onboarding many smaller clients.
There are some good points here, and to be clear, I am not suggesting that customer concentration automatically disqualifies a company from being a good value opportunity. Rather, the way I think about customer concentration is that it creates a rebuttable presumption that future revenues are riskier than revenues derived from many smaller sources.
There are a number of ways to rebut this presumption. Where the company’s major customers have been stable for an extended period, this lends support to the ideas in the readers’ arguments above. For example, consider Air T, Inc (NASDAQ: AIRT), a microcap air cargo company whose major customer, Fedex (NYSE: FDX), consistently accounts for half of its revenues. Though concerning, this fact becomes somewhat less worrisome when we recognize that FDX has been a major customer throughout AIRT’s history, and back in the mid 1990s accounted for a whopping 90% of its revenues.
The duration of the relationship is just one consideration. Though AIRT and FDX have been dealing with each other for decades, their relationship is governed by short-term contracts that can be terminated on very short notice. It is up to the individual investor to balance out these facts and determine if this is a risk he is willing to take on.
The key to all of this is that the investor needs to look past the customer disclosure and consider the totality of the situation before rejecting the company as an investment opportunity on customer concentration risks. There may be long-term contractual tie ups or other factors which contribute to increase the cost of switching providers which can give the investor comfort despite the concentration.
Moving on to another point in the readers’ argument is that the costs of maintaining one large account are lower than the combined search and maintenance costs of many small accounts. While this is almost undoubtedly true (at least in terms of marketing costs), it ignores the overall profitability of the accounts. As mentioned in an earlier post on Porter’s Five Forces, when a customer has significant bargaining power a firm supplying that customer tends to find these sales less profitable. This can be due to volume discounts or other preferential pricing, or it can be from providing costly services as “sweeteners” which would not be provided to smaller accounts. The net effect is difficult to discern with certainty (one could compare the company’s various line item expenses as a percentage of revenue with similar companies which have less concentrated revenues), but I would guess that a major customer is going to tend to be less profitable than many smaller customers, all else equal.
How do you deal with companies that have highly concentrated revenues?