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Thoughts on customer concentration

 

“Tell me where I’m going to die, so I’ll never go there.”- Charlie Munger

A large part of successful investing lies in not being stupid, as opposed to being smart. It is usually much easier to avoid an obstacle course rather than fight your way through it.  Since the most important part of our analysis process is the risk of permanent capital loss for clients, there are several features of a potential investment that can be “deal-breakers” for us. We have no interest in these types of companies, and will end our research process on the stock if we see a deal-breaker. Some deal-breakers includes technological obsolescence, management fraud, or material regulation risk. For this blog post, I want to focus on one deal-breaker in particular: customer concentration.

“Customer concentration” in a company means that a small number of customers make up a meaningful percentage of the revenues. The risk of investing in a company with high customer concentration is obvious. If you own a chocolate store and there is only one boy who buys your chocolate, your store has a high degree of customer concentration. If that boy found a better place to buy chocolate, your entire business would die. In 2017 alone, there have been two examples of companies that have blown up due to the loss of a major customer:

Imagination Technologies (IMG.L)

Imagination Technologies is a British company that develops technologies for GPUs (Graphic Processing Units) for smartphones. Apple paid a royalty for the use of Imagination’s graphics technology, and Apple was Imagination’s largest customer representing over 50% of Imagination’s revenue. On April 2, 2017, Imagination issued a press release stating that Apple has decided not to use Imagination’s technology for future products. The result was as follows:

Aimia (AIM.TO)

A little closer to home, Aimia is the owner of the Aeroplan loyalty program and was spun-out of Air Canada in 2002. Aimia makes money by selling Aeroplan points to Air Canada and Aeroplan branded credit card issuers such as TD and CIBC. Again, over 50% of revenues were tied to Aeroplan.  On May 11, 2017, Air Canada announced that it would end the contract with Aimia in 2020 and launch a new loyalty program.

The key lesson is obviously that customer concentration risk matters. It seems highly unlikely that either Imagination or Aimia will ever return to their previous heights, creating a permanent loss for investors of both companies. Digging a little deeper, here are a few observations about customer concentration:

1) Imagination and Aimia had very little control over their future. No matter how brilliant the management of either company was, it would likely not have changed their ultimate fate by much.

2) The motivations of Apple and Air Canada were different, but this ultimately didn’t matter. Observers say that Apple’s decision was not driven by costs, since the royalties paid to Imagination are breadcrumbs compared to the scale of the whole company. Apple simply wanted new technology that Imagination was unable to deliver. Air Canada was likely purely motivated financially. Air Canada gave Aeroplan an allocation of 8% of its seat capacity at a discounted rate to the market, and launching a new loyalty program would allow Air Canada to gain back the cash flow.

3) In the case of Aimia, the potential loss of the Air Canada contract was partly anticipated by the market. The dividend yield on Aimia’s stock before the announcement was around 10%, suggesting that investors had a high degree of uncertainty regarding the future of the company. If Air Canada had renewed the contract, the stock would likely have risen by a significant amount. The most unlikely scenario for Aimia would have been the stock to stay where it was. At Baskin we try not to invest in these kind of binary situations, no matter what the upside is.

Can customer concentration ever be a good thing? Yes. For small companies, it may signal to potential clients that it possesses the capability to be a supplier of a large firm. For example, a company with a new design for a car part would gain credibility if Toyota or GM adopted the part for a future design. For the most part, however, we will skip a lot of pain if we just simply pass on buying highly concentrated companies rather than pick the odd success.

Ernest Wong