One of the most important risks facing a company is that demand for its products will drop. That risk is lessened if the company has a wide assortment of products that it sells to a large number of customers. Conversely, if customers are highly concentrated, the company faces additional risk.
Consider JAKKS Pacific (JAKK), maker of toys and related products. While the company enjoyed over $900 million of sales last year, consider the concentrated sources of that revenue:
While none of these companies is in imminent danger, they must be constantly monitored to ensure things stay that way. For example, consider how Magna International's sources of revenue went from a strength to a weakness in the course of a few years.
Of course, a customer's potential bankruptcy is not the only cause for concern when a company has a concentrated number of clients. The company under consideration is also subject to the whims of its customers, who can leverage the importance of the relationship to the company by pushing down profit margins. Wal-Mart, JAKK's largest customer, has a history of squeezing out every last penny from its suppliers, particularly those who are dependent on Wal-Mart for the bulk of their revenues.
By considering and understanding the sources of a company's revenue, investors can better shield themselves from being blindsided by downside risk.