Nonsystematic Risk – Part 2

Nonsystematic risks are risks that are unique to a specific company, industry, asset, or investment.

In Nonsystematic Risk – Part 1, we reviewed management, operational, and competitor risks.

Today we will look at a few more nonsystematic risks, including: key customer; key supplier; credit (default); legal.

Key Customer Risk

Are there any customers that make up a significant portion of the company’s revenues? If so, there is a financial risk to the company if their business is lost.

For many businesses, heavy reliance on one or two customers is a common occurrence. The greater the concentration of one’s revenues, the greater the risk to the business.

For example, Dynacorp, a (fictional) small publicly traded company, obtained a 5 year government contract to provide specialized parts for the armed forces. This contract makes up 90% of Dynacorp’s revenues. As the government is quite generous, the parts have an excellent margin and Dynacorp is extremely profitable.

At the end of the 5 years, the government puts the contract out to tender. Dynacorp loses out to another vendor. Their revenue stream falls to almost zero and Dynacorp must quickly find new sources of revenue or face insolvency.

The same issue, in a slightly different context, also applies to mutual funds.

If there is too much exposure to one investment by the fund, adverse changes in the price of that investment could negatively impact the fund’s overall performance.

There is an old saying, “Don’t put all your eggs in one basket.” If that one basket slips, every egg will break.

To the extent possible, never put all your company’s revenues in the hands of one customer. Be leery of investing in a company which relies on very few key customers. Nor put too much of your investment capital in any one asset.

Questions to Ask

The notes accompanying a company’s financial statements may provide information on key contracts or clients. I suggest you always give them a read when analyzing investment options. In fact, starting with the notes and then working your way back to the actual statements is usually a good policy.

For companies with a few key clients, try to determine what would happen if those customers leave. Can the lost revenues be easily replaced? Often, this is difficult in the short term.

In our Dynacorp example, the company sells specialized army parts. The probability that Dynacorp can quickly find another buyer is small. In all likelihood Dynacorp will need to redesign their parts to meet the needs of other potential users and/or attempt to secure new contracts with other armed forces. This will take time and possibly capital to redesign their product offering.

Is there any reason that the key customers cannot leave?

Perhaps there is a long-term purchase contract in place. Maybe the company provides a vital product to the customer that cannot be acquired elsewhere. Or possibly there is a special relationship (e.g. partnerships, cross-ownership, family ties, etc.) between the customer and company that increases the probability of the customer remaining loyal.

If any of these are present, there may be reduced concern over losing the key client. However, if the customer goes bankrupt, then relationships, contracts, etc., may not mean anything.

Key Supplier Risk

Another thing to look for is the reliance on any key suppliers. As with key customers, review the financial statements for relevant contracts or even large amounts payable to specific companies.

If a company relies on one supplier, it has little leverage against price increases. If these increases cannot be passed on to its own customers, that will negatively impact profitability.

What happens if the supplier falls into business difficulty and is no longer able to provide the needed products? If a company cannot get needed supplies, they will have difficulty serving their own customer base. That will mean lost revenues and unhappy clients.

For example, your business operates a fishing lodge in northern Canada. Two airlines service your lodge. ClearSky is your preferred carrier due to better prices and flight times. Whereas JunkJet has a poor reputation and service level. Everything goes well for your lodge. ClearSky is an excellent business partner and your customers are always happy with the service.

Unfortunately, ClearSky changes its business model and no longer serves your lodge airport. You are forced to use JunkJet. As the “only game in town”, JunkJet raises their prices 100% for flights to the lodge. To be competitive with other fishing lodge options in the north, you cannot pass on all the increase to your clients. As a result, your profit margins fall.

Then, due to poor flight quality, overall customer satisfaction in your lodge falls and complaints on TripAdvisor increase. Business begins to suffer even though the lodge itself continues to provide first class service. Unless you can find a new air carrier, there is a good chance that you will be out of business in a year.

When considering investing in companies with key suppliers, be aware that this scenario can easily occur.

And if you are managing a business, always try to avoid having to rely on one or two key suppliers.

Questions to Ask

When reviewing businesses, look for any reliance on key suppliers and the steps taken to ensure a continuous supply at previously agreed upon prices.

This might be indicated by the supplier having a special relationship with the company. Or perhaps there are fixed contracts in place that assure price and volume.

Also, consider the business health of the supplier by looking at their financial statements and available public information.

Credit (Default) Risk

Companies, like individuals, enter into contractual arrangements that often impose financial obligations. This may be buying inventory on credit, paying accounts payable within 30 days of invoice receipt, or owing taxes to the government.

To raise capital, companies often issue debt or equity instruments to investors. The debt and certain types of equity (typically preferred shares) require the company to pay interest or dividends to the investors for a period of time. At the end of the specified period, the company will pay back an agreed upon amount to the investor. In the case of preferred shares, there may be no expiration date.

The decisions that an individual company makes and the consequences of resulting actions impact that company’s profitability and cash flow. There are macro-economic factors that play a part, but the company’s own actions are the key to its cash flow.

For a supplier, government, or investor, credit risk is the probability that the company will not generate the cash flow to make good on its financial obligations. Investors may not receive their interest or dividend payments and may not receive all of their capital at the end of the agreed term.

Questions to Ask

The only question you need to answer is whether the company has the cash, and the desire, to pay its financial obligations. A review of the financial statements will give you clues.

Focus on cash balances and current assets. Are there adequate liquid assets to pay the company’s short term obligations?

Does the company have any significant financial obligations? Have they entered into any new arrangements that may place additional strain on the company? For example, has the company entered into any agreements to acquire buildings or equipment? Do they have any unfunded pension plans that require a cash infusion?

Has the company (or government) reneged on any previous obligations? This may address the desire to pay their debts.

If you are a creditor (say a bond investor) and assets have been pledged against the debt, is the market value of the assets in excess of amounts owing? What is the liquidity of the asset? Can you receive market value if selling the asset in a distressed sale to pay the debt? Are there other debt holders ahead of you if there are claims to the pledged assets?

Legal Risk

The risk that actions taken by the company will result in loss due to legal actions.

Product liability issues may result in warranty, recall, or losses from lawsuits.

For example, let us say Dell’s new laptop has a tendency to overheat. Numerous customers return their laptops under warranty for repair or replacement. This costs the company money.

Because the problem seems to be structural, Dell decides to recall all of the affected model. They will provide cash refunds or replace the computers with upgraded models. Another cost to the company.

Finally, a group of customers who suffered burns from the computers band together and file a class action lawsuit against Dell. The customers claim that Dell knew, or should have known, that the computers would injure its customers. The suit requests punitive damages against Dell of $10 Billion. If the case goes forward, there will be significant legal fees, adverse publicity for Dell, and the possibility of a judgement that costs them a lot of money.

Legal risk may also result from corporate negligence.

After the Gulf Coast oil spill, British Petroleum (BP) faced many lawsuits relating to corporate negligence and related matters. Even if the suits are unsuccessful, they will still cost BP substantially in time, money, and reputation.

Questions to Ask

Does the company engage in activities that increase the possibility of legal action against it? The greater the number of activities that could result in legal issues, the greater the chance that something will occur.

Has the company been involved in legal action against it previously? If so, what were the results?

Okay, that is enough for today.

I expect that this investing thing is a little more work, and a little less exciting, than you thought it would be.

Risk and return are the building blocks for all things investment related. So we will spend a little bit of time with them in detail. I think the effort up front will make our later discussions easier to digest.

We will look at one more example of nonsystematic risk in our next post and then move on to something new.