Monday, June 22, 2009

When Customers Are Too Few

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.

Disclosure: None


Anonymous said...

Does selling a fair bit of product to the same customers also add efficiencies though? For example, sales may be more steady (enabling a company to take advantage of efficiences of scale in production and lower storage costs), lower levels of inventory would need to be kept on hand, etc.

I assume that the supplier would enter into agreements with Walmart, Target, etc. that stipulate volume and price of goods sold. The supplier may be extra vulnerable when these contracts reach their end. While they are in effect though, wouldn't these companies be less risky than companies that may, at any time, be faced with inventory pile-ups, etc.?

Saj Karsan said...

It may certainly add efficiencies, but the point of the article is to encourage consideration to the risk of the revenues (and as a result, the earnings).

I agree that when there are contracts, this mitigates risk. In many cases, however, there are no contracts. An examination of the company's annual report should reveal whether this is the case.