Avoiding Customer Concentration Risk is the Key to Long-lasting BusinessKen Bradley
Everyone is happy to land a big customer. With large orders comes rapid revenue growth, enhanced credibility and increased exposure of products to potential customers and markets. However, don’t be blinded by these numerous benefits; winning big customers is always a double-edged sword. If only a few customers dominate your revenue you will face customer concentration risk. Losing any of these big customers would have far-reaching impact on the short-term survival of your company.
Forbes Magazine has noted that customer concentration risk is one of the biggest risks to business. As a matter of fact, high customer concentration carries considerable risks that can far outweigh any benefits in the long run. As a rule of thumb, if one customer accounts for 10% or more of your total revenue or if your five largest customers account for 25% or more, the customer concentration risk is considered high.
Though everybody knows that putting too many eggs into one basket bears potential risk, it is not difficult to name some companies which have blown up by doing so.
Imagination Technologies Group plc is a British-based technology company which deals in semiconductor and related intellectual property licensing. It derives approximately half of its business from its licensing to Apple.
Shares plummeted more than 70% right after Apple’s April announcement that it would stop using Imagination Technologies in their processor and instead develop their own independent graphics design. Imagination’s market capitalisation dropped from £754m to £290m. Surprisingly, Apple is not only the company’s largest customer but also its fourth-largest shareholder with a stake of just over 8 percent. While this may have given a greater sense of security to Imagination Technologies, being a major shareholder didn’t change Apple’s strategy of insourcing graphics design. On September 22nd, Imagination Technologies agreed to be acquired by Canyon Bridge Capital Partners for £550m.
Imagination Technologies Group is not an isolated case. In 2016, Dialog Semiconductor Plc received about 74% of its sales from Apple and approximately 92% of its sales were from the top five customers – a significant customer concentration risk. The company’s shares plunged more than 20% – the biggest intraday decline in more than 16 years – after Karsten Iltgen, an analyst at Bankhaus Lampe, warned that Apple may cut back on the use of the Dialog’s power-management chips and develop its own power-management integrated circuits.
Similarly, shares of Ambarella Inc. (a video-chip maker that serves camera maker GoPro) plunged 22% overnight after they released their Q2 results and simultaneously reduced outlook in Q3 and for the balance of fiscal 2018. This was their first decrease after five consecutive quarters of year-over-year growth. Ambarella noted that a “substantial decline in GoPro revenues and a moderate decline in the drone market” would adversely affect its revenue.
Direct shipments to GoPro accounted for 19% of Ambarella’s revenue in fiscal 2017. The company has found it difficult to meaningfully diversify away from its largest customer and, as a result, its stock has been on a roller-coaster ride with the changing prospects for GoPro over the past few years.
If a significant portion of the total sales of a business are concentrated in a few customers the consequences can be disastrous. You are handing control over the company to your large customers. Revenue can be a deceiving number, don’t be misguided by the mirage of your revenue growth. If you have high customer concentration, that growth is not sustainable. When a large customer runs into trouble, decides to purchase from your competitor or takes development of the same technology in-house the revenue decrease in your company will hurt cash, margin, market share and investor’s confidence.
Although there are a handful of sad stories about business decline due to loss of big customers, I still believe that winning these customers is more of a blessing than a curse. Risk management and mitigation is an absolute necessity and must be mandatory to effectively undertake high customer concentration. Some key elements include:
Long term contracts
Sign long term contracts with your major customers, this makes it more difficult for them to switch and secures more time for you to diversify your business.
Improve customer relationships
Continuously improve and enhance the customer relationship by building trust, providing excellent service/delivery and staying competitive among peers so that you are viewed as a vital supplier that cannot be replaced. You must make sure that you understand the customer’s changing needs and preferences and take these into account when you develop your strategy and products.
Diversify your customer base
Allocate more resources to expand the customer base, reducing over-dependence on your large customers. Better still, target customer growth in different industries and geographic locations. Initiate new marketing and sales programs to attract small clients, they’re easier to land than the big ones. Growing gradually through small contracts allows a business to adjust and manage their customer base expansion more effectively.
Diversify your product line
With consolidation happening every day it becomes increasingly tough to diversify your customers within a segment because each segment may be dominated by a handful of companies. You need to expand your product lines to serve customers in different segments to allow for business diversification.
The most effective way to mitigate customer concentration risk is through diversification. Having all of your eggs in one basket may look efficient but will expose you to substantial risk of an enormous downturn. The compounding effect of a demand slump from your big customers is far more devastating than you can imagine. When the worst scenario comes true, you may not have the chance to cut operating expenses fast enough to survive. The slashed revenue may not be able to cover the operating expense, leading to negative operating income and cash flow rupture. Your stock price will dive. Depressed stock prices increase the cost of borrowing because banks must take a company’s share price into account when deciding on whether to extend credit and what interest rate to charge. If your company cannot get enough cash inflow, bankruptcy or sell are the only options left. Even if your company is lucky enough to get sufficient cash inflow, it is extremely difficult to turn things around considering that companies with high customer concentration have a higher cost of capital – particularly for debt. Deployment of a diversification strategy will help provide sustainable revenue streams to build a long-lasting business.
Han Di is a contributor at the operational and strategic levels in supply chain development and is a Supply Chain Specialist at Silecta Inc., a supply chain services company.