In 2012, I wrote a post on my former blog, Valuation Speak, titles Zynga and the High Cost of Concentrations.  In that post, I talked about two key concentrations that were causing its stock price to be battered.  The first had to do with a concentration in revenue in two games, Farmville and Mafia Wars.  Large decreases in revenues from both games were disclosed in the second quarter of 2012.  The second concentration was the fact that about 90% of Zynga’s revenues were derived from operating on the Facebook platform.  Zynga was being hurt because a small change in Facebook algorithms had made it more difficult for customers to find Zynga’s games.  The post concluded with the following conclusion:

Concentrations can affect value.

I have used a basic valuation equation to illustrate the fact that business value is a function of a trilogy of factors, expected cash flow, the risks associated with the future receipt of those cash flows, and the expected growth of the cash flows.  The equation is repeated here:

Concentrations create additional risk relative to similar, but unconcentrated businesses.  Higher risk shows up in r, the discount rate in the equation above.  If risk is higher, other things being equal, then value is lower.  This makes common sense.

Concentrations Come in Numerous Forms

In the remainder of this post, I’ll list just a few of the many kinds of concentrations that businesses can face and make short comments.  I think they will speak for themselves.  On another day, I’ll come back and illustrate some of these concentrations with real life examples.  So here is a beginning list of business concentrations you might want to  recognize.

1. Customer concentrations.  Dominant customers may contribute a substantial portion of sales and earnings.  Every customer relationship has a beginning, a duration, and an end.  And while that relationship is in existence, the dominant customer may recognize its market power and exert margin pressure on a company.  Walmart is a good example of a company that has become a dominant customer of many private businesses, and they have not hesitated to keep margin pressure on many of their suppliers.  It is absolutely no fun to be around a company when a dominant customer is lost.  Sometimes companies simply don’t recover.
2. Supplier concentrations.  If one supplier provides most of a company’s products, bad things can happen.  The supplier can go out of business.  I’m reminded of a company who had a dominant supplier.  That supplier was acquired by the company’s fiercest competitor.  Shortly thereafter, its supply of product was severed.  It is always good to have secondary sources of suppliers.
3. Management/manager concentrations.  Some companies, especially small, private companies, are dominated by a key manager, often the owner.  Things run well while he is in charge, but they are, in many cases, likely to fall apart if something happens to that key manager.
4. Key product risk – obsolescence.  Some companies have a dominant product that may account for 50% or more of their business.  There is a risk of evolving obsolescence over time unless new products are always being created.  I’m reminded of a company that makes analog telephone switching equipment.  There is no longer a market in the United States for these products, and the only remaining markets are in third world countries.  That is what could be called creeping obsolescence.
5. Key product risk – competition.  If you have a dominant product and aggressive competition, there is always risk that significant business can be turned away, either through lower pricing, better service, or just bad luck on your part.
6. Key employee loss.  I’m reminded of a company that had a dominant salesman.  The owners never got around to providing him with any equity in their business or even a better incentive plan.  They did not even have a noncompete with him.  The employee recognized that 40% of the company’s sales were directly to his customers, with whom he had great relationships and who depended on his knowledge.  He established a new company in the same town, taking three other salesmen with him who accounted for another 40% of the original company’s business.  Within months his new company was going strong and profitable, while the original company was contemplating liquidation.
7. Key location is deteriorating.   Many retail operations are dependent on the health of their nearby neighborhoods.  If neighborhoods (or even regions) deteriorate and a company does not respond by creating new locations, a slow decline can occur that, over time, can become debilitating for the business.
8. Key service risk – competition.  All service providers like to think they are unique in the way they approach their markets.  However, many customers do not necessarily agree.   Some providers may be considered “more unique” or better for any of a variety of reasons.
9. Key service risk – regulation.  I am very familiar with this risk.  in early 2oo1, President Bush signed a law “repealing” the estate tax for a period of years.  The effect of this regulatory change was swift for Mercer Capital.  Business related to gift and estate tax planning accounted for close to half of our business.  Almost immediately, about half of that business was gone.  We had to scramble to bring on new service lines quickly and did a good job of recovering.  But full recovery took a couple of years.
10. Key service risk – technology.  When I first was in business back in the early 1980s, fax technology was incredibly expensive.  We could not afford a fax machine and had to turn cartwheels to get anything time-sensitive faxed, to pay a proverbial arm and leg.  FedEx took advantage of this situation and created a service called Zapmail.  With that service, I could create a document in Memphis today, and call FedEx for pick-up of the physical document.  They would pick it up, take it to a processing center, and send it by fax to the closest FedEx processing center near the location where I wanted to send the document.  They would print off the fax there, and often, during the same day, the document could be delivered to its destination.  It was a great service that was upended by the rapid development of fax technology and the plummeting in its price.  This was not a dominant service for FedEx, but you get the picture.

Concentrations Create Risk

We have already made the point that concentrations create risk that impact value.  I use the header for emphasis after listing just ten forms of concentrations that create risk for businesses.  Just reading the list should make business owners more aware of any potential concentrations in their businesses.  And reading the list should sensitize advisers to the importance of discussing concentrations with their clients.

Work on Concentrations While You Can

If there is a dominant risk in your business, it is a good idea to begin to address the issue as best you can and as quickly as you can.  I say this because we never know when a concentration risk can be triggered in a business.  It is unlikely that your dominant customer will go away, however, the risk that they will leave you is greater than zero.  Your existing products or services will become obsolete or change dramatically over time.  If you are not changing with customer demands, your concentration can be your demise.

So don’t wait until it is too late to acknowledge your concentration(s) and begin to work on them.  I’ve said this  before and I’ll conclude with the following:

Don’t wait until it is too late to work on things you know you need to work on.  When it is too late, it is too late.

Before You Leave

The stock market is still crazy, with the Dow Jones Industrial Index dropping 470 points yesterday on “weak China data.”

Regardless of what is happening in the public stock markets, private business owners must stay focused on building and realizing value from their businesses.

If you would like to talk about any valuation-related matter during this period of “correction,” please give me a call (901-685-2120) or email (mercerc@mercercapital.com).

Until next time, be well!

Chris