By Adam Wong, chief editor of The Fifth Person
We have a “formula” for investing profitably in stocks and we call it the Investment Quadrant. The four quadrants we analyse before we even invest a single dime in any company are:
- The business model of a company
- The leadership and key management of a company
- The company’s financial performance
- The company’s stock intrinsic value
I won’t going into each individual quadrant today but I’m going to highlight one critical area when analysing a company’s business model — risks.
In the Investment Quadrant course, we list five major risks that a company might face and potentially put it out of business. As an investor, if a company goes bust, that’s obviously bad news because you stand to lose your entire investment.
And one of these major risks is an over-reliance on one (or a few) major customers.
The Logic is Simple…
If a company relies on ONE major customer for the bulk of its revenue, what do you think will happen if that major customer decides to hightail and leave one day?
The company is going to suffer a major hit to its income and in the worst-case scenario, it could go bankrupt.
Which is exactly what happened to GT Advanced Technologies Inc. (NASDAQ: GTAT), a tech-manufacturer listed on the NASDAQ, when Apple (NASDAQ: AAPL) decided not to use the company’s scratch-resistant sapphire glass for the iPhone 6.
GT Advanced filed for Chapter 11 bankruptcy last week, sending its stock plummeting by more than 90%, from $11.06 to $0.80, in a single day.
Chart: Yahoo Finance
So What Happened?
It’s no secret that suppliers and manufacturers everywhere want to work with Apple. With hundreds of millions of iPhones and iPads sold globally every year, bagging a contract with the tech giant can help a supplier multiply its revenues. Working with Apple also helps suppliers secure contracts with other companies as many see Apple as the “ultimate resume builder”. Because of these potential rewards, many companies are willing to take risks and enter into one-sided deals with Apple.
In GT Advanced’s case, the company had a deal to build a factory in Arizona to manufacture sapphire glass exclusively for Apple, but which Apple had no obligation to buy.
So when Apple decided to go with Corning’s Gorilla glass for its iPhones, GT Advanced was dealt a financial blow that may ultimately see the company go out of business.
While netting a mega-contract with a huge customer like Apple is a financial bonanza for almost any company, it can become a double-edged sword.
If a company is able to use its windfall to net more customers and diversify its business, its risk is better mitigated. If not, when one major customer contributes the majority of a company’s revenues, any pull-out would be financially disastrous and a risk that investors should plainly avoid.
ABOUT THE AUTHOR
Adam Wong is the chief editor of The Fifth Person and was featured on Singaporean English radio station 938LIVE as a guest expert on MoneyWise. He is also the author of Singapore national bestseller Lucky Bastard! which made the Sunday Times Top 10 Bestseller’s List in 2009 and Value Investing Made Easy, which made the Kinokuniya Business Bestseller’s List in 2013. An avid investor himself, Adam shares his personal thoughts and opinions as he journals his investing journey online. If you’re interested to learn more about stock investing, you can join The Fifth Person Newsletter and receive free weekly insights on how you can generate higher returns and dividend income from the stock market.
* The opinions expressed in this post are those of the author and do not necessarily represent the views of Business Insider.