Don't Overlook This Dangerous Vulnerability

Companies with robust sales and profits and growth rates can get investors drooling. But in some cases, those shiny metrics might conceal a critical vulnerability that brings with it heaping piles of risk. Many companies' promising numbers belie their dangerous dependence on a very small clutch of customers.

Bloomberg Businessweek recently noted that several Indian outsourcing specialists are highly reliant on U.S. customers for their income. Infosys Technologies (Nasdaq: INFY  ) gets 66% of its revenue from North America, while Tata Consultancy Services gets 58% of its revenue from the U.S. Unfortunately for both of these companies, Congress recently more than doubled the fee for work visas in the U.S., from $2,000 to around $4,300. Thus, their costs to send workers to America periodically has just skyrocketed, putting pressure on profits.

That's not the only threat these outsourcers face. The state of Ohio recently banned the outsourcing of its information technology work to foreign companies. If other states, or possibly the entire country, follow suit, a huge revenue source for foreign outsourcers will shrivel up, even if U.S.-based rivals such as Cognizant Technology (Nasdaq: CTSH  ) benefit. Partly as a defensive move, several foreign outsourcers have been buying U.S. companies -- nearly $2 billion worth over the past decade, per Bloomberg data.

The Wal-Mart effect
When a company is too dependent on one or a few customers or customer groups, it occupies the wrong side of the balance of power. The company may have to accept tough terms to avoid losing crucial revenue. Back in 2007, Forbes offered stark data on the dangers of an overconcentrated customer base. It looked at 333 companies that sell to Wal-Mart, and found that the greater their percentage of sales to the company, the lower their gross margin:

Wal-Mart Sales as Percentage of Total Sales

Gross Profit Margin

Less than 10% 39.1%
10% to 20% 36.2%
More than 20% 35.4%

Data: Forbes.

Concentrate on concentration
As investors, we need to keep an eye on overdependency in our companies. Many people fear that AT&T (NYSE: T  ) is too dependent on revenue tied to Apple's iPhone, and worry about what will happen when Verizon Wireless or other competitors start offering their own versions of Apple's signature smartphone.

Companies themselves watch this issue no less keenly. Motorola (NYSE: MOT  ) has waxed bullish about its Android phones, suggesting that in order for Verizon to avoid a similar overdependence on Apple, the wireless carrier will push the rival Android platform, including Motorola products, as well.

Dominant companies that enjoy long-term success often have others dependent upon them, instead of the other way around.

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Longtime Fool contributor Selena Maranjian owns shares of Apple. Vodafone Group and Wal-Mart are Motley Fool Inside Value picks. Apple is a Motley Fool Stock Advisor recommendation. Wal-Mart is a Motley Fool Global Gains selection. The Fool owns shares of Apple and Wal-Mart Stores. Try any of our investing newsletter services free for 30 days. The Motley Fool is Fools writing for Fools.


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