For the same reason your financial adviser preaches about the merits of a diversified portfolio, the individual companies you invest in should be looking for ways to diversify their “portfolio” of customers. In other words, nobody should put all (or even most) of their eggs in one basket.
That doesn’t mean companies always do what they should.
And yes, any discussion about too much reliance on a corporate customer is going to push Apple (NASDAQ:AAPL) to the top of the list of talking points, as several of its suppliers depend heavily on the success of the iPhone to spur demand. It’s hardly just Apple giving rise to what could be considered “parasitic” stocks, though.
Here’s a look at several scenarios where one organization is dangerously dependent on one customer for a big chunk of its business:
If you’ve ever played Words With Friends or FarmVille, then you’ve played a Zynga (NASDAQ:ZNGA) game. There’s also an outstanding chance you found those online games with a visit to your Facebook (NASDAQ:FB) account; the social networking giant fuels 90% of the game publisher’s revenue. That’s great as long as Facebook can continue growing like it did in 2009. As most all of us know all too well, however, Facebook’s growth rates are slowing, and its engagement stats (like length of visit and frequency of visits) are waning.
To Zynga’s credit, the company is trying to wean itself from the Facebook funnel. It recently unveiled its own social gaming platform that it hopes will directly draw as many as 1 billion online gamers. As it’s apt to learn though, being a “destination” website on your own can be a lot tougher than being a “diversion” from a much bigger bucket. So, until and unless Zynga proves its own social networking solution can draw a crowd, we have to assume that if Facebook stumbles, it’s bringing Zynga down with it.
OK, it wouldn’t make sense to list several dangerously dependent companies and then ignore the fact that Apple has created more than a few of these situations. The scariest one of all, however, might be chip supplier Cirrus Logic (NASDAQ:CRUS).
In revenue-percentage terms, Cirrus isn’t the most dependent on Apple. That honor has been won by Skyworks (NASDAQ:SWKS) in recent quarters. But, with Apple accounting for more than half of Cirrus’ revenue, one has to wonder what happens if and when iPads and iPhones finally become passé.
Many investors might not be familiar with Demand Media (NYSE:DMD), but odds are good that investors have stumbled across one of the websites it operates. Its most popular (and most visited) property is www.eHow.com, which offers tips and “how-to” guides for everything imaginable.
Of course, being a web-based business and reliant on web traffic to generate revenue, it’s directly affected by how well those pages — and the entire website, for that matter — rank in the eyes of the dominant name in search: Google (NASDAQ:GOOG). So, while Google wasn’t a paying customer in the traditional sense, the fact that Demand Media relied on Google for more than two-thirds of its traffic effectively meant Demand Media was running a big risk; What if Google changed the way it ranked web pages?
Well, as it turns out, Google did. In early 2011, Google changed its search criteria to specifically lower the search rankings for so-called “content farms” like the one Demand Media was operating. Though the company said the overhaul didn’t impact it, it pretty much crushed similar content-driven sites like www.suite101.com and www.mahalo.com. There’s no reason another overhaul of Google’s search engine algorithm couldn’t land a direct hit in the future.
Metropolitan Health Networks
It’s often overlooked, but single-company dependency is alarmingly common in the health care delivery and insurance arena. One of the more troubling relationships within the sector is the relationship between Metropolitan Health Networks (NYSE:MDF) and Humana (NYSE:HUM).
Metropolitan Health Networks offers health services to Medicare patients, mostly in the southeast U.S. Problem is, it relies on Humana’s Medicare Advantage plan for more than 90% of its revenue. What happens if Humana changes its terms? And, given the unbalanced status of the industry as we head toward the implementation of Obamacare, that’s very possible.
What’s at Risk?
While we haven’t seen any major implosions because of a company’s concentrated customer base in the past few months, there’s a great example from late last year of how this risk can come back to haunt you.
Last December, American Superconductor Corporation (NASDAQ:AMSC) shares tumbled 40% in one day when it announced a key customer — Sinovel — had refused to take shipment of wind turbine parts. Unfortunately, Sinovel made up 80% of American Superconductor’s business. The customer has never come back to the table.
The stock has been chopped by another 75% since then, as sales have fallen to only 25% of their normal levels before Sinovel backed out. American Superconductor has been taking heavy losses in every quarter since then.
Lesson learned: Never say it can’t happen to you.
As of this writing, James Brumley did not hold a position in any of the aforementioned securities.