FedEx & the U.S. Postal Service: Does Customer Concentration Affect Value?

Customer concentrations are a risk for any business having them. Public companies must disclose any customer relationships which account for more than 10% of their revenues.  Public investors are interested in them and in being able to assess the degree of those risks.  Two recent announcements by sizable public entities highlight the importance of customer concentrations.

FedEx and the U.S. Postal Service

FedEx Corp. announced on July 17th that its contract with the U.S. Postal Service expires in September 2012. According to a Reuters article:

  •  FedEx is the Postal Service’s largest contractor
  • The Fedex contract, which has been in force since 2000 with extensions, is set to expire in September and will be up for rebid
  • The contract accounts for $1.5 billion, or over 4%, of FedEx’s $43 billion in sales
  • United Parcel Service (UPS) is the logical competitive bidder
  • FedEx will definitely attempt to retain the contract, but likely on less favorable terms if it succeeds, which some think is likely
  • The contract renewal will cast an overhang on FedEx shares until the issue is resolved

FedEx shares fell 1% during the day of announcement.  With a market capitalization of some $29 billion, this represented a decline of $290 million in market value.

SAIC and Lockheed Martin

SAIC, Inc. recently announced that it lost its largest government contract to Lockheed Martin Corp.  In a Bloomberg release and from SAIC we learn:

  • Revenues for SAIC are about $11 billion
  • The contract was estimated to provide “base revenue” of $1.9 billion over three years, so on an annual basis, it provided about 6% of revenues
  • One investment bank lowered its 2014 EPS estimate for SAIC from $1.38 per share to $1.26 per share
  • SAIC plans to protest the contract loss and there is some chance that it could be regained

SAIC shares fell as much as 5.2% during the day of announcement and closed down 3.1% for the day. With a market capitalization of some $4 billion, the closing price represented a decline of $120 million in market value.

Business Valuation Implications

The fact that a company has customer concentrations is important.  That’s why business appraisers always ask for an analysis of revenues (and profitability in many instances) by customer.  Customer concentrations definitely create risk and must be considered in business valuations.

Many years ago, Mercer Capital valued a distribution company on an annual basis.  The company was profitable and growing.  Management was always a bit dissatisfied with the relatively low multiple we placed on their earnings. Remember the basic valuation equation:

We considered the risk of the customer relationship in the discount rate, r, which was utilized in the appraisal.  Obviously, if r is increased, (1 / (r – g)) decreases, and value is decreased as a result.  With FedEx and SAIC and their recent announcements, the fact of the potential losses caused a laser focus by the markets, if only for a short while, and value was affected.

More background on this client company from years ago:

  • The company’s largest customer accounted for about 60% of sales
  • Growth at the business was fueled by rapid geographic expansion of the largest customer
  • The relationships between company management and the management of the largest customer were excellent
  • Obviously, we asked about this relationship every year at appraisal time
  • According to management, there was “no chance” that they would lose this customer relationship

But something changed.  One Friday afternoon, the largest customer was acquired.  On Monday, the contract between our client company and the largest customer, which was only verbal after many years, was terminated.  Within two weeks, all business had been diverted to the favorite suppliers of the acquiring company.

Our client company did survive.  Fortunately, they had retained some earnings, responded quickly to the loss, and hunkered down.  It took a number of years for them to return to reasonable levels of profitability, but they did.  Their next annual appraisal reflected a sharp decline in value, but not nearly so much as would have been the case had we not made specific consideration of the concentration risk.

Lesson Learned

The lesson I learned there and elsewhere is this:

Every customer relationship has a beginning, a duration, and an end.

What the markets are saying in the examples of FedEx and SAIC is that the loss of a customer is a time to reevaluate not only that relationship, but other customer relationships as well.

Business appraisers must focus on the risk of customer concentration, as well as other forms of concentrations (suppliers, products, geography, etc.).

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