For the 7^th time in 10 years, Wal-Mart is #1 on the Fortune 500 list (in the other 3 years, it was #2).  The company is the largest private employer in the U.S. and accounts for 8% of total retail sales in the US. As big box retailers (including Wal-Mart, Target, The Home Depot and others) have gained market share over their smaller competitors, consumer products companies feel the need to sell to these large retailers in order to grow sales.  For some companies, however, selling to the big box retailers has a darker side – what we call “Wal-Mart Risk.”

Customer Concentration Risk

The risk is customer concentration – that a significant portion of a company’s sales are to one company.  The dangers of customer concentration include:

1)    Credit risk – the risk that the customer will go bankrupt and the company will be unable to collect its receivable.

2)    Switching risk – the risk that the company will build capacity to satisfy a large customer, and then the customer switches to another supplier, leaving the company with significant excess capacity (and perhaps unsold inventory).

3)    Buyer power – the risk that the customer uses its position as a large buyer to drive down the price it pays the company for goods.

In order to address customer concentration risk, revolving credit agreements that include a borrowing base often exclude accounts receivable from customers above certain concentration limits (say 10% of total receivables).  This provision significantly limits revolver availability for some borrowers and does not protect lenders from the main risks of customer concentration – switching risk and buyer power.

How is Wal-Mart Risk different?

How should we look at customer concentration risk differently when the large customer is Wal-Mart or one of the other big box retailers?

1)    Credit risk is significantly reduced.  It is unlikely that Wal-Mart will go bankrupt and not pay its suppliers.

2)    Wal-Mart takes advantage of its buyer power more than most.  The downside of selling to big box retailers is that they will demand lower prices, leaving their suppliers with lower margins.  In addition, Wal-Mart is well known for setting other strict terms for its suppliers in terms of product quality, inventory levels, distribution and returns.

Can we “structure around” Wal-Mart risk?

So how should lenders address the ever-increasing Wal-Mart risk among their borrowers?

1)    Waive concentration limits for receivables from high quality vendors, like Wal-Mart, but consider lower advance rates to account for the higher dilution likely from aggressive return and warranty claims.

2)    Consider the impact of the loss of a large customer on the borrower.  Does the company have a contingency plan?  Will it be able to bring down costs and capacity to match lower sales?

3)    Lower leverage!  Companies with significant customer concentration have higher business risk than companies with a diverse customer base and should thus have a more conservative financial strategy – that means less debt.

Have you seen companies and/or their lenders address this risk?  Tell us how – we welcome your comments.