So far as part of the great industries for investment series, we've taken a look at four "green dot" industries that are generally attractive for investment, and four "red dot" industries that are probably best to stay away from:
"Red Dot" Industries
"Green Dot" Industries
Today, we wrap up the "red dot" list with something that isn't a particular industry, but more a common characteristic to avoid at all costs.
We are talking about the "parasite" business model. What is that, you ask? Let's dig into it...
What is a Parasite Business Model?
A parasite is defined as: "an organism that lives in or on another organism (its host) and benefits by deriving nutrients at the host's expense.". That definition can easily be extended to the business world. Countless companies make large portions of their business by selling to one or a handful of customers which they totally rely on for survival. It is more frequently referred to as "high customer concentration".
We generally define a company as "parasitic" when it relies on a single customer for over 25% of revenues, or gets 40% or more of revenues from just 2 customers.
This is pretty easy to figure out if you are doing research on your own. The SEC requires companies to specifically call out any customer that accounts for 10% or more of sales. A quick skim through the "Business Summary" section of a 10-K filing should quickly confirm whether or not you've got a parasite on your hands.
Why is it Bad?
It should be pretty obvious why this kind of business model is not one you want to invest in, but let's walk through the reasons anyway.
First, and most obviously, the company constantly faces the risk of its "host" customer(s) deciding not to do business with it anymore. It could be because a competitor has created a better product, or has found a way to under-price you. Or it could be that your host has decided to take the product or service you supply in-house. Whatever the case, if the host stops doing business with the parasite, the parasite's very survival is in serious jeopardy. That's not a risk we want to be investing into.
Also, even if the host continues to do business, it knows that the parasite relies heavily on it for survival. This gives the host serious pricing leverage. "Accept my terms or die" is the basic situation the parasite has to deal with. This makes sustained, profitable growth extremely difficult for the parasite. Such difficulties are not something we want to be investing into.
Where to find Parasites?
The parasitic business model is most common in suppliers of industries with just a few, large players. It is more common to find parasites amongst small-cap (under $1 billion market cap) stocks, but it is not impossible to find them even in the large-cap (over $5 billion) space.
One notable example are suppliers to the mobile device space. Consumer mobile device market share is dominated by Apple (AAPL), and Samsung, who together account for over 40% of mobile phone shipments. Component suppliers to this space, then, are often parasites to these two firms. Apple, in particular, has more than its share. Cirrus Logic (CRUS) gets over 60% of its revenue from the iPhone maker, and Skyworks (SWKS) over 40%. Being an Apple parasite has quite a few risks... just ask GT Advanced Technologies, which went bankrupt trying to supply sapphire glass to them. Apple also has a nasty habit of taking a lot of its component design in-house, leaving out suppliers in the process.
Another example is the "meta-search" business model, which has been utilized with limited results to piggy-back on dominant search engines. In the online travel space, this can be seen with Trivago (TRVG), which gets over 80% of sales from just two customers: Booking.com (BKNG) and Expedia (EXPE). TripAdvisor (TRIP) is in a similar boat, relying on those two customers for 45% of sales. The business model has been tried on general search as well, but failed (InfoSpace is a good example). All of these attempts have ended up relying on Google (GOOG) for 80%+ of sales.
Finally, consumer branded retail distribution has largely consolidated in the U.S. to one channel: Walmart (WMT). From small toy-maker Jakks Pacific (JAKK) to large multi-product firms like Clorox (CLX), numerous consumer goods firms are beholden to Walmart for 25% or more of sales. To us, this limits their attractiveness, even if these firms have products with regularly recurring sales and strong brands. Walmart thrives on price competition, and that's not good for suppliers.
While not an industry, per-se, the parasitic business model is EVERYWHERE, and investors are well-served to make looking for it a key part of the due diligence process. Investing in a parasite is almost guaranteed to limit your potential returns, and more frequently, the investment will stagnate or even decline, as it is in the best interest of the host to limit the parasite's success. After all, there are only so many profit dollars to be made on each sale, and the host is in a far better position to collect more of those profit dollars for itself. Avoid parasites at all costs.