Friday, Oct 16th 2020

The other side of concentration

Commentary

In investing, "customer concentration" refers to when a company derives a meaningful portion of its revenue from one or a small handful of large customers. Often viewed as a risk and source of volatility, it means one-off changes to a few customers can have an outsized impact on the company.

However, we think customer concentration can ironically be a revealing indicator of a business that's poised to grow exponentially.

Take Fastly and Twilio for example, which we discussed yesterday. (We own these stocks for our clients in Opportunities and Flagship, respectively).

Both companies at some point had individual customers that represented over 12% of total revenues - TikTok in the case of Fastly, and Uber in the case of Twilio (back in 2017). Both companies also saw dramatic fluctuations in their stock prices due to this customer concentration. Fastly just experienced this yesterday, but Twilio went through a near-identical experience back in 2017. 

Early that year, Twilio plunged 26% in one day after reduced spending from Uber drove a cut in topline forecasts. But in the three years that followed, Twilio went on to 10x its stock price while increasing its annual revenue base by more than 100x the value of that original shortfall.

Did Uber dramatically ramp its spending back up? No. Twilio's Uber exposure actually kept declining as the strength of Twilio's offering attracted new customers ranging from startups to titans of industry at similar scale as Uber. That's the other side of customer concentration that often goes unappreciated. 

While customer concentration can happen for many reasons, it can be an indication of a very high quality product intersecting with a company still early on its growth curve - an attractive dynamic for long-term investors.

It's not easy for a young company to build a product that's so good it passes the smell test of even the largest customers (like Uber). When that happens, often the result is customer concentration. But it's just one of the many signposts of a small company able to hook a fish that typically swims in a much larger pond. 

As Twilio has shown, in a big enough pond, you don't need to catch every fish to bring in a large haul. We think Fastly will follow a similar journey.

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