How customer concentration affects industrial business value

Why does one large customer change the value?

A business deriving 55% of its revenue from one mining customer carries a different risk profile from one with 50 smaller customers. Both may be equally profitable today. The difference is how many decisions stand between the business and a sharp fall in earnings. For the concentrated business, one decision is enough: a re-tender, a procurement restructure, a choice to bring maintenance in-house, a change to the mine plan, or a new owner of the customer.

The second effect is bargaining power. A customer that knows it is half of your revenue can push on price, payment terms and scope. That often shows up as a lower margin on the largest account than on the rest of the book, which is visible only when gross profit is measured customer by customer.

Concentration is common in industrial businesses. Manufacturers grow around an OEM, engineering workshops around a processing plant, and service businesses around a mine. It does not make a business unsaleable. It does mean the value depends on evidence about that one relationship, not just on the profit it produces.

How should concentration be measured?

Start by deciding what counts as one customer. The useful question is who makes the decision to keep buying. Australian accounting standards take a similar line: AASB 8 Operating Segments requires entities within its scope to disclose when revenue from a single external customer is 10% or more of their revenue, and treats a group of entities known to be under common control as a single customer. In practice, three mine sites owned by one miner may each have a maintenance budget but share a procurement team that could change suppliers across all three at once.

Then measure at three levels. Revenue share is the headline. Gross profit share shows whether the big customer is also a low-margin customer. The earnings effect, which is the one a buyer cares about, shows what would actually be left if the customer went, after the overheads that could realistically be cut.

Measure over at least three years and look at the direction. A customer that grew from a quarter to half of revenue over three years tells a different story from one that has been steady at half for a decade with several contract renewals behind it.

What does 55% of revenue mean for earnings?

The gap between 55% and 77% is the point. Fixed costs do not leave with the customer, so the earnings at risk are larger than the revenue share suggests, even when the big account earns a thinner margin. A business with 50 smaller customers loses and replaces a few each year as a matter of course, and that churn is already reflected in its earnings.

What makes a large customer less risky?

Not every concentrated relationship is fragile. These are the questions we work through, usually with the contract in hand.

• Term and renewal. How long the current contract has to run, how many times it has been renewed, and whether renewal has ever been contested or re-tendered.
• Termination rights. Whether the customer can end the contract for convenience on short notice. Where it can, a long term gives less protection than it appears to.
• Change of control and assignment. Whether the contract can be assigned in an asset sale, and whether a share sale triggers a consent requirement or a right to terminate.
• Pricing. Whether rates are reviewed against an index or fixed for the term, and how cost increases are passed on.
• Switching costs. Site inductions, approved contractor status, qualified procedures, specialist equipment or tooling held for the customer, and the time it would take a competitor to qualify.
• Breadth of the relationship. How many people in your business deal with how many people at the customer, and whether it all rests on the owner and one site manager.
• The customer's own outlook. For a mining customer, how long the site is expected to operate. An ASX-listed miner must include a mineral resources and ore reserves statement in its annual report under ASX Listing Rule 5.21, which is a useful public starting point.

Mining-specific contract terms, site access and commodity exposure are covered in more depth in how to value a mining services business and on our mining services business valuation page.

How is concentration reflected in the valuation?

There are three ways to reflect it, and the valuer has to choose rather than use them all. If the loss of the customer is likely, for example because the contract ends and will not be renewed, maintainable earnings are adjusted. If the risk is real but the outcome uncertain, it is reflected in the capitalisation multiple or discount rate. In some cases a scenario analysis weights the possible outcomes. Reducing the earnings and raising the risk rate for the same exposure would count it twice.

The purpose of the valuation matters. In a sale, buyer and seller can share the risk through deal terms: an earn-out tied to renewal, a deferred payment, or a retention. In a shareholder valuation, a family law matter or a tax or restructuring valuation there is no earn-out, so the risk has to be priced into a single figure at a single date. That usually produces a more cautious number than a seller would hope to achieve with deal protections in place.

How do a large customer's payment terms affect value?

Large customers often set the payment terms, and long terms tie up cash. On a $4.4 million account, every extra month of debtors is roughly $367,000 that the business has to fund from its own working capital or its overdraft. A buyer pays for earnings net of the capital needed to produce them, so a big customer on slow terms is worth less per dollar of profit than the same customer paying in 30 days.

How a normal level of working capital is set, and what public information exists on how large customers pay their suppliers, is covered in how working capital affects a manufacturing business valuation.

Are there other kinds of concentration?

Customer concentration has relatives that a buyer will also look for.

• Supplier concentration: a single source for a critical input, a distribution agreement that can be withdrawn, or one steel or resin supplier on unusually good terms.
• End-market concentration: many customers, all in coal, residential construction or one agricultural sector, so a single downturn hits them together.
• Geographic concentration: a business built around one mining region, one port or one industrial estate.
• Relationship concentration: customers who deal only with the owner, which turns customer risk into key-person risk.

What can an owner do before a sale or valuation?

Diversifying a customer base takes years, and a valuation reflects the business as it stands at the valuation date. Some steps can be taken sooner and make a measurable difference.

1. Produce gross profit by customer for three years, so the concentration is presented accurately rather than discovered in due diligence.
2. Seek renewal or extension of the major contract before going to market, and have your lawyer review its termination and change of control clauses.
3. Broaden the relationship so more than one person in your business deals with more than one person at the customer.
4. Review pricing terms so cost increases can be passed on.
5. Record the switching costs that protect you: approvals, inductions, qualified procedures and specialist equipment.

If you are considering a sale, our business sale valuation page explains how an independent valuation fits into the process, and acquisition valuation covers the same questions from the buyer's side. Fees are fixed and shown on pricing. We confirm the fee in writing before we start. No hourly billing.