High on Customer Concentration? How too much love can kill your company
Remember the 80/20 rule: where 80% of something comes from 20% of something else? Well, if your Customer Concentration (CC) as a percentage of sales looks anything like the 80/20 rule, it’s your Scarlett Letter, marking your company as a potentially dangerous high risk stay-away from investment.
Dateline: 2011. To mark the times, a new era in middle market and small business lending and enterprise value has taken hold. Near financial catastrophe in the last 24 months has called to question not only loose lending practices, but also the financing and M&A deal frenzy which peaked two years ago.
Pile on the reasons: post market crash, post financial bail-out, post Madoff, we have seen in the last 24 months not only a drop in valuation multiples, but also a great deal more scrutiny of what lies behind your numbers. Newer middle market transaction services called Quality of Earnings reviews have sprung up to help banks, and business investors truly prove the bottom line is accurate and sustainable.
For middle market companies, where 95% of the businesses fall between $5mil and $100mil in annual sales, 2011 is calling for a closer scrutiny of earnings drivers than ever before. In the modern age of Wal-Mart and China, rising to the top of many Risk Premium Adjustment lists is Customer Concentration. And the questions are simple: Where are your sales coming from? Who are your customers? And how sustainable, protected, and accurate going forward are your figures?
The primary target for this review is your customer base. And if you don’t already know it, by the end of any serious financial review of your company, the amount of CC contribution to total sales will be revealed for all. And if the results showcase any CC with more than 10% of sales, you could be cited for recklessly endangering the life of your company, and killing it’s future for someone else. Here’s why.
According to research based on the 2010 US Census and the University of Florida’s Center for Economic Development which crunched the Census figures, the number of middle market businesses that change hands in a given year has nearly doubled from 20,000 businesses sold in 2002 to an estimated 38,000 in 2011. The reason for the increases is said to be retiring Baby Boomers and the dramatic rise of Private Equity firms using MBA superstars to seek out, analyze and identify well performing companies to target for acquisition. The data analysis further revealed nearly 30% of all middle market businesses are now owned by Private Equity Groups (funds). In other words, with the revitalized increase in the number of businesses trading hands, buyers are likely to be even pickier going forward. Meaning, in a risk-averse environment, a simple handshake deal won’t do it anymore. In fact, other financial services firms like Commercial Banks, Investment Companies, Asset-Based Lenders, Private Equity Investors, and even the government by way of the SBA are taking notice. And if your company is found to be harboring a dirty little CC secret somewhere in the dark recesses of your A/R journals, the danger of exposure can kill the value of a company in an instant.
Two recent public examples provide us a measurable insight as to the potential financial impact of high CC. Take Nanometrics Inc for instance, NANO once sold $200million of micro-processing technology until Intel, 20% of its sales, decided to shop elsewhere in 2011. NANO lost $30mil in sales instantly, and their stock dropped 19%. More worrisome is that before Intel went away, 60% of NANO’s sales came from only 3 customers! A classic high CC volatile company, and irresponsible in many ways too.
Another company servicing the Solar industry among others, American Superconductor Inc, recently (AMSC April, 2011) learned that it’s biggest customer, in China, decided to stop taking delivery of its 40% share of AMSC sales until further notice. The stock dropped 44% in a matter of minutes. If High CC can potentially eliminate large chunks of your sales instantly, what about large chunks of jobs and people counting on them?
High CC damage is not restricted to just public companies, or business owners who need bank funding or want to sell or retire out of the company. Consider any middle market company seeking capital. According to Ibbotson Associates (a Morningstar investment research & advisory firm) an additional 5% Risk-Premium adjustment to a company valuation, say for high CC, can hack off nearly 20% of the value of your company compared with other risks. Consider if your company is seeking a new Line of Credit, or rolling one over. You now face a bank lending committee that may decide to deny your application after new lending criteria tightened the rules since the last go-around. Is the lender at fault if they decide to decline any new credit exposure to avoid the risk of default should a single customer of yours walk away? SBA lenders, in fact will ask for a detailed explanation of any customer activity whose sales account for 10% or more in total sales. Are you surprised?
When I ask clients, those who have been cited for high CC, or even high ‘Supplier’ Concentration levels, they shrug, “What can I do? It’s business,” they tell me. “It keeps the lights on and more people working,” they say. Well I’m all for that, but not at the expense a high CC hit can do to enterprise value, and the future of jobs you could have protected by taking action sooner. So what should you do now to avoid a potential nightmare later?
Here are 5 ways to reduce High Customer Concentration:
1) Diversify the Base:
Find, or create, or buy different lines of products (SKUs) you can sell to the same consumer base by using different distributors, retailers, or wholesalers, etc. Try new channels at various price points and locations. Try to bundle several products and services into a single package deal, like McDonald’s Happy Meal, or online retailers. “Nice shirt, need a tie? How about a deal on socks to go with those fancy new shoes? At least recognize that things have changed. And if you are a Wal-Mart high CC vendor for instance, and your brand isn’t yet a household name such as Clorox, wherein 27% of sales comes from Wal-Mart, you should plan to diversify your customer base and product lines into other channels ASAP.
2) Make an Acquisition:
Find another company to merge with, or acquire one. One that has a complementary product or a wider distribution network will help spread customer concentration risk across a wider segment. In fact, many M&A deals are entirely based on this premise in the first place. According to the University of Florida’s research more companies are coming to market after the 2008-2009 crash opening the door for a quick way to diversify your customer base and product line. A good M&A advisor or business broker can help identify potential M&A targets that make sense for your business.
3) Phase-out high CC Accounts:
Fire the customer it’s called. Often times, high customer concentration comes with low margins. Owners justify the high volume (low profit) as a means to keep things moving. Unfortunately this attitude simply cannibalizes future business capacity to service higher margin customers. Spending too much money and effort to service a single high volume customer with specific needs, such as expensive manufacturing equipment, RFID packaging, increasing “Return” credits, or impossible delivery deadlines can lock you in, and permanently reduce your capacity to service future customers. Unless a high CC customer is ready to ‘guarantee’ your business a lifetime of sales, or unless your business has a very high barrier-to-entry as an integrated supplier might have in the auto industry, look to find a strategy to phase out high volume, low margin, customers with more diverse and profitable ones.
4) Pretend you want to Sell the Company:
It’s a fact; those owners who prepare to sell their company at least 12-18 months before they seek a buyer are known to develop a plan to clean things up. Not unlike selling a home, repainting in and out, these sellers dump past due A/R to a collection agency, they pay off debt, they streamline P&L expenses, and, they focus like a laser on increasing and incentivizing more sales and profit across a wider customer base. The goal is such that no one customer is more than 10% of sales. Many sellers, by the end of this exercise ask why they didn’t take such action sooner. Well now you can. Try it. Act like you are internally committed to getting the best price for your company and shareholders. The outcome of such a faux sale action plan in place today can immediately help identify ways to fix high customer concentration issues without having to sell the company.
5) Internalize the problem:
If you’re stuck with a high CC and can’t give it up, there’s still some hope. Let’s say you’re like thousands of Wal-Mart suppliers, using that one customer to keep the lights on. What can you do if anything to prevent a sudden loss? The answer is still to diversify your sales, however, do it within the walls of the customer itself, Wal-Mart for instance. Is it easy? No. Can it be done? Yes. If your contacts within a customer’s own purchasing organization can reach across more lines of business, and away from any single concentrated buyer group, or key decision maker that can kill your business with one phone call, you may buy more time. In fact, lenders and investors do understand the situation you’re in and how to get out of it. They simply won’t pay you (increase the Value) or lend to you when (with a high CC risk) something could go wrong. Instead they will offer you a substantial discount or penalty for all your hard work and move on.
So there it is. 5 ways to fix high CC. Is High CC a new phenomenon? No. But, is it a growing risk that any business takes in the face of potential catastrophe should a key account walk away? Absolutely, and the actions outlined above are preemptive ways to avert that danger. Do the analysis and check for yourself. And then ask; ‘If we lose a key customer, will that seriously jeopardize the business and staff we worked so hard to build?’ If so, you now know there is something you can do about it. So let’s get started. Let’s fix it.
Part of the new Fix-It series by Rick Andrade [Summer 2011]