Small Cap Risks: Customer Dependency Risk

From an investor's point of view, small cap companies are often exposed to a number of risks that are far more commonly experienced compared to larger companies. These risks are reasons why small cap companies do not always reach high valuations or even industry average valuation multiples. Indeed, a large number of companies trading on low multiples during the height of bull markets are often exposed to one of the main risks, which include customer dependency, exchange rate impacts and liquidity problems, amongst others. Investors should therefore be able to assess for some of the most common risks to avoid getting caught in a 'value trap' - a situation when a company looks 'cheap', but with good reason. This three part series will look at a few of the main small cap risks. Company reviews will promptly resume thereafter. This is part one of the series.

What is the Customer Dependency Risk?

The customer dependency risk comes in two main forms, which both revolve around the same point:
1. Where a large percentage of total revenues are generated from one or a few customers
2. Where one of a few large contracts account for a large proportion of total revenues

That are actually very similar issues that relate to something called Earnings Quality. Earnings quality is a qualitative (i.e. non-numeric) measure of the quality of a company's earnings. One of the main points within earnings quality is sustainability. Are the earnings that the company achieves recurring, or are they non-recurring - the higher the level of recurring revenues, the higher the earnings quality. That will become clearer later when we look at point 2 - where there are a few large contracts.

If Customer Dependency risks do exist, then it makes sense to value the company on a discounted range of valuation metrics to reflect the chance of an unwelcome shortfall in revenues opening up.

C.D Risk: Few Customers

For now let's look at Mechanical PLC, an imaginary company that manufactures robots for car manufacturers, and let's look at Tablet PLC, an imaginary company that develops and sells security software to businesses to help protect their computer infrastructure. The first thing to identify is the target markets and how each company sells into that market to identify customer dependency risk with respect to the number of customers.

Mechanical PLC sells its robots through direct contracts with the car manufacturers. The car manufacturers come to Mechanical PLC and place an order for a large number of units upfront and signs a contract at an agreed price. Let's assume that Mechanical PLC only has four customers who each contribute to a large percentage of total revenues. The risk is present because if one of those customers was to switch to another robot manufacturer, then Mechanical PLC would lose a large proportion of its revenue stream. Earnings quality is low in this respect.

On the other hand, Tablet PLC sells direct to over 200 businesses, all of relatively similar size. The software is sold on a 'per computer per year' basis, so none of these businesses account for more than 2% of total revenues and the revenues are strongly recurring. That means that if Tablet PLC loses one of the 200 customers, the impact on total revenues (and thus earnings) is negligible, and could easily be offset by any growth in revenues elsewhere. There is therefore a greater degree of security in forecasting future revenue streams and there is much lower risk of losing a large proportion of the revenue stream. Earnings quality is higher since there are many customers and no contract accounts for a large proportion of revenues.

You can check for the nature of the customer base through looking at both the terminology used by management and by looking through the company accounts - this usually outlines the proportion of revenues that any major customer accounts for.

C.D Risk: Few Large Contracts

When you hold a stock and a large contract win is announced, how do you react? In all cases, it is immediately good news for the company, who will have just secured a large amount of revenues to boost the top-line growth. However, is that contract recurring or not? If that contract is not recurring, then there is the risk that the short-term boost in share price will fade away in time, assuming that there are no additional contract wins. To make it clearer, let's look at an example with Mechanical PLC.

Mechanical PLC experiences irregular sales patterns. Its robots have a lifespan of 15 years and two of the car manufacturers only purchase robots when they are setting up a new car manufacturing facility - revenues are not recurring. The other two car manufacturers purchase £1 million in revenues in year one, and combine to purchase an additional £0.10 million in revenues in each subsequent year. It's easier to see this in a table.

Mechanical PLC has £1.00m in revenues in Year 1 - to keep it simple, post-tax profits are 10% of Mechanical PLC's revenues. As stated above, in year 2, two of the car manufacturers combine to contribute an additional £0.10m ahead of the £1.00m they were already contributing. Therefore, total revenues rise to £1.10m and post-tax profits rise to £0.11m. At this point, an investor may want to value Mechanical PLC on a multiple of its profits - let's say 8x profits. Therefore, Mechanical PLC is valued at £0.88m, which sounds fair.

However, in year 3, Mechanical PLC announces a very large £6m contract win. £3 million of those revenues fall into Year 3, £2 million fall into Year 4 and £1 million fall into Year 5. When the contract win is announced, the market realises that Mechanical PLC now looks cheap based on its forecasts. It is forecast to make £4.20m in Year 3 (£3.00m + £1.20m from the two customers) and that will generate post-tax profits of £0.42m. At this point, let's say that the investor now applies a premium because the investor sees growth and thinks that Mechanical PLC may grow even faster. The investor is now willing to value Mechanical PLC on a 10x profit multiple of the Year 3 earnings. Now, Mechanical PLC is valued at £4.2m, a massive uplift on the £0.88m before.

But at that point the investor and the rest of the market is relying on one key point - that Mechanical PLC will win other large contracts, at which point the financial performance will benefit from revenues stacking on top of each other. The market is essentially pricing in an increase in earnings quality through more customers or more contract wins. But as Years 4 and 5 pass, Mechanical PLC fails to win any more contracts because its two car manufacturer customers are not building any new facilities. The other two customers still contribute +£0.10 million per year, but as Year 6 comes into play, the £6 million contract is complete, and post-tax profits are now lower at £0.15m. Over Years 3, 4 and 5, the market has not been impressed by the lack of contract wins, and Mechanical PLC's valuation has fallen by 50% - that alone shows the massive risk if you bought on the spike.

Yes, that is still higher than before, but we must now remember that the market is valuing Mechanical PLC at £2.1m now, and profits are only £0.15m. The market might now revert back to valuing at 8x profits and Mechanical PLC's new valuation is £1.2m, so there is an additional £0.9m of downside. 

Buying on the initial contract win was a vote of faith in future operations because the contract win was not recurring. How can you avoid these situations? Check whether the revenues are recurring (via reading the RNS) and check how the revenues are loaded. Are most of the revenues due to fall in Year 1 and tail off, or will they fall evenly. Is there scope for further contract wins to prevent the share price falling, and can the new valuation support a lack of further contract wins?

An Example in a Chart: Security Research Group (LSE:SRG)