As the saying goes, “You can tell a man’s character by looking at his shoes”, similarly, you can spot the character of a business by looking at the characteristics of its customers. Below is an attempt to provide you with a framework enlisting some Key Questions around Customer of the Business which I often try and ask within, while analysing any company. After all, A prudent question(s) is one-half of wisdom.
# Who is the Core Customer of the business?
Just thinking about this question enables to get some sense about the size of the opportunity. There would be certain products or services which would be available to only to an adult, say, cigarette or liquor, automobiles, etc., as compared to a toothpaste (FMCG), footwear, etc. which is used by all, irrespective of age, etc. So, next time, when the company’s management talks about how India is under-penetrated as compared to the developed economies, considering its population of 1.3 billion and the growth potential there-of, one should ask: Is the entire population an addressable opportunity to begin with?
For Hero Motocorp (‘Hero’) selling 2-wheelers; adults, especially males would constitute their core average customer. Also, one family would typically have 1 two-wheeler. So, the addressable opportunity for the business in India would be 325 million (1.3 billion population / typically 4 members in a family). For Hindustan Unilever (‘HUL’), selling toothpaste to pampers, its’ opportunity size is 4x larger than Hero Motocorp, i.e. the entire Indian population of 1.3 billion.
# Do the customers buy on Credit?
Answering this question enables to identify Credit Risk of the business. To me, it is one of the most powerful aspects of understanding the market power of business. While most of the FMCG companies, Amusement Parks, Retail sell typically either in cash, i.e. no credit risk, or their receivables as % of net sales is less than 5%, i.e. minimal credit risk. On the other hand, Heavy Engineering, Engineering, Procurement, Construction (‘EPC’), Steel and Power businesses typically have a substantial portion of their sales locked in receivables, thereby not only being susceptible to Credit Risk, but also resulting a strain on the working capital and thereby Cash Flow from Operations.
BHEL, one of India’s largest engineering enterprise has approximately 80% of its revenue emanating from debtors, and loss allowance, including impairment losses at INR 354 billion is 1.2x of the FY 2018 revenue
Wonderla Holidays, the largest amusement park of India sells tickets and food having no debtors on its books.
Increase in the Accounts Receivables / Net Sales over a period of time indicates that the business is undergoing stress. This may be on account of increasing competition or on account of its declining brand power. After all, increasing market share at the cost of cash flow is like a leaking ship!!
# What portion of their budget do the customers spend on the business’s products or services?
If the customer spends a large portion of his budget on the product or service, his price sensitivity towards the product / service is very high. The customer would have more bargaining power as compared to the business, thereby business being the most sensitive. Imagine you going to purchase a loaf of bread vs an automobile vs a house. Obviously, price sensitivity towards purchasing an automobile would be higher as compared to buying a loaf of bread. You would want to look at various options, both from a pricing and a value perspective. However, when buying a home, even the customers who are usually not very demanding would get into a negotiation mode – After all, it’s a very large budget of the customer’s saving / income. Hence real estate would be the most price sensitive. Cyclicality in a FMCG business is minimal as compared to automobile and greatest in real estate.
The below chart clearly indicates highest Revenue sensitivity for DLF (largest Indian real estate developer) followed by Hero Motors (largest 2-wheeler maker in the world) and then the least sensitive being HUL (largest personal care company in India).
Larger the customer’s portion of budget, greater the revenue sensitivity of the business.
# What is the Customer’s Dependence on business?
Customer’s dependence of the business can be classified as under:
- Need to have: Cigarettes, Toothpaste, Salt and now Phone and Internet are Need to have products; businesses which sell these products or services will continue to sell them, the pace of growth could undergo a change in some years, however, on a whole, their demand would continue to remain – dependence of the customers on their business is a given – can’t go away (unless the business wants to flounder by acting silly!!). Hence, most of the FMCG companies always trade at a higher multiple (30 to 40 times earnings) as compared to industries which cater to “Nice to have” products / services
- Nice to have: Businesses which are into providing automobiles, real estate, paints, hotels have large element of customer discretion. Dependence of the customer on their products / services can be postponed and at times, may not even materialize.
Hence, customer dependence on the business determines the sustainability, cyclicality and profitability of the business. Greater the customer’s dependence on the business, higher would be business sustainability, lower the cyclicality and greater the profitability (mostly) and vice versa.
# Is the customer base concentrated?
Concentration of the customer base, from a geographical, value or demographic standpoint are important to understand, since it helps in determining concentration risk of the business. With more than 40% of its sales emanating from outside India via exports, Bajaj Auto’s customer base is far less concentrated in India as compared to Hero Motocorp, whose sales are predominantly India focused, more than 90% of its revenue comes from India. If India were to be growing as compared to rest of the world, you know where to put the money.
Below example of JHS Svendgaard Laboratories, wherein its termination of contract from its sole customer, P&G, resulted in the company losing large chunk of revenue and large capital erosion for its shareholders.
If, by just trying to answer some basic questions about the customers of the business, one can get such meaningful insights, imagine what can be achieved!! After all, you don’t need to jump over 7-foot bars: look around for 1-foot bars that you can step over.
Disclaimer: Please note that these are my personal views. While, I am NOT a registered Research Analyst as per SEBI (Research Analyst) Regulations, 2014, all investors are advised to conduct their own independent research into individual stocks or industries before making any decision. In addition, investors are advised that past stock performance is not indicative of future price action.