Getting Squeezed

There are some companies who are dependent on just a single company for a bulk of their revenues. I had invested in one such company some time ago but did not realize this concentration risk. I had bought the company as the market was not factoring in the increased capacity that the company would have. When I look back I realize that capacity addition cannot be the sole reason for buying, as the margins that the company makes on that incremental capacity might be very different. The company I had bought was Hitech Plastics, the company derives 80% of its revenues by selling plastic containers to Asian paints. Now if Asian paints wants to protect its margins in an rising input cost scenario, the first place they will cut their margins is where they have the highest bargaining power and that will be guys who are solely dependent on them and hitech fell in that category.

Next consider the case of a company called Shah Foods which is basically a bakery company, the company does contract manufacturing for Britannia biscuits. The company is 100% dependent on Britannia for its revenues and the company in its annual report acknowledges the fact that they have been trying to diversify its revenue base, and the demand from Britannia is highly erratic and irregular. Their financial performance speaks of the same.

Next the most recent example which actually prompted me to write this article, Mphasis derives 80% of its revenues from HP and yesterday in the results reported by the company there was a mention of the company giving price cuts to its parent company. Now people are questioning the corporate governance issues, but is it not a matter of lack of pricing power and bargaining power rather than corporate governance? It simply shows the solutions being provided by the company to HP are not differentiated and there are other competitors who are willing to provide the same service at a lower cost. Had the company’s product being in-substitutable, the price cut would not have happened as the possibility of switching from one service provider to another involves a lot of costs and effort and time.

Had the company not taken a price cut, HP might have moved to some other solutions provider, the revenues would have taken a further beating and hence the profits. There are numerous companies that take a price cut to push their products, but the fact here is accentuated by the fact that the cut is taken for a customer from where 80% of revenues come, this leaves the company vulnerable to further price cuts since it bulged once, it might bulge once again.

After my learning’s from Hitech I have decided not to invest in companies which are hugely driven by one customer and even if I would invest it would be at a huge huge discount to the multiple that other firms are trading at in the same space.

Mr. Porter said it long ago, look at the bargaining power with buyer and suppliers.