If a business has a more diversified customer base, the business probably won’t even mention this as a risk. Instead, it may state that it is not dependent on a small number of customers.
Also, you need to watch for trends in customer concentration. For example, clothing maker Liz Claiborne became more exposed to specific retailers as many department stores went out of business. This has increased Liz Claiborne’s dependence on a few customers, such as Macy’s, which now represents a large percentage of Liz Claiborne’s sales.3
9. Is it easy or difficult to convince customers to buy the products or services?
Think about businesses that use aggressive sales tactics, such as time pressure, to sell their products or services. You will often see these businesses advertise, “Sign up now or lose the opportunity of a lifetime.” If a business needs to rely on these aggressive sales tactics, then the product or service is not being sold based on its merits but instead on the ingenuity of the salespeople. Businesses that rely on high-pressure sales tactics to sell their products or services typically do not have sustainable business models and are typically not good for the customer.
10. What is the customer retention rate for the business?
Determine whether a business is retaining its customers or if it is constantly turning them over (churning them). The longer a customer is retained by a business, the more profitable that business becomes. Most of us acknowledge that it is more expensive to gain a new customer than to retain a valued one. Another reason: A loyal customer base generates more predictable sales, which can improve profits. Customers also often serve as advocates for the business, which brings in new customers and more sales. In the long run, the businesses that spend time cultivating long-term relationships with their customers are more likely to succeed.
The customer retention rate is the most common metric for tracking customer longevity. It is usually offered as a percentage, which tells you from period to period how many customers are sticking around. Unfortunately, you will only be able to calculate or track customer retention rates for certain types of businesses, such as those that earn recurring revenues from subscriptions or franchise fees. For example, FactSet Research Systems, a financial research solutions provider, disclosed (in its 10-K from August 31, 2010) that its customer retention rate was 90 percent, compared to 87 percent the year before.
Also, if businesses that earn their revenues through subscription models do not disclose their customer retention rates, this should serve as a red flag. This may indicate they have low retention rates, making it a poor-quality investment.
One method you can use to estimate customer retention rates is to monitor the number of customers who are enrolled in loyalty programs. If a business has a loyalty program, it will often disclose the number of members that are enrolled in the program in the 10-K. Customers who enroll in loyalty programs are typically repeat customers.
For example, in its December 31, 2009, 10-K, Western Union said it had more than 13 million active cardholders in its Gold Card loyalty program, a 10-fold increase since the program was launched in 2003. Watch for declining loyalty program numbers as well, as this can serve as an indicator that customer retention is declining.
You should also find out if the business is making investments to retain customers. You can often ask the investor relations department of a business this question, or you can gain insights by reading historical articles written about the business. For example, when I researched Tesco, a leading U.K.-based grocer, I read many articles about Tesco’s commitment to retaining customers. In order to learn more about its customers, Tesco began issuing a loyalty card. Tesco’s card, like most, is used to track customer behavior, including stores visited, products purchased, and even method of payment. Tesco uses the results of its analysis to inform its product development and selection, which helps it satisfy local tastes when it moves into new areas.4
It is also helpful to interview the sales staff of a business to understand if there is an incentive to retain existing customers. You do not need to talk to many salespeople, as your goal is simply to understand how their incentive structure relates to customer retention. It is easy to locate most salespeople because their contact information is typically found on a website. Call or e-mail them and tell them you would like a few minutes of their time and that you would be happy to share your research with them. You can also call or e-mail investor relations and ask them this question.
You want to learn if the salespeople are rewarded for retaining customers. Do they receive a commission both at the time they make a sale and when the customer renews? Or do they receive a commission only when they make a sale? For example, insurance agents typically are given a commission each time a customer renews an insurance policy with the existing insurance underwriter. Therefore, insurance agents have an incentive to retain customers. What do you think would happen if an insurance agent were given a commission only at the time they sold an insurance policy to a customer? They would need to go out and constantly find new customers, and all of their time and effort would be devoted to that goal. This is why insurance businesses pay commissions both when customers purchase policies and when they renew policies, providing incentives to agents to retain customers.
One final factor to consider as you evaluate the customer retention rate is whether a business is selective about the types of customers it will do business with. If they are selective, consider it a good sign. If certain customers are more profitable because they are easier to attract or easier to retain, look for the high-quality businesses that focus on these more profitable customers.
For example financial research provider FactSet prefers selling its services to multi-manager asset-management firms rather than single-manager asset-management firms. FactSet believes that sales to related customers under the same roof are naturally much easier to make than sales to entirely new prospects, who are less familiar with the quality of the company’s products and the level of support it offers its users. By selling to multi-manager firms, FactSet can sell more products to related customers, instead of having to make single-user sales, which are more difficult to make.
11. What are the signs a business is customer oriented?
The more frequently a business interacts with customers, the more critical it is to keep those customers happy. If a business interacts less frequently with customers, customer satisfaction is less important. For example, how often do you replace your dishwasher? Probably not often, so a bad customer experience may be less important than the performance of the dishwasher over a long period.
Ask yourself if the business is easy to do business with. Think about your experience with different businesses: Don’t you prefer to frequent those businesses that are easy to do business with? Of course! For example, if you buy a television at Costco and it doesn’t work, you can easily return it without many questions being asked. You do not have to go through a process of locating a supervisor to explain why you are returning the item or spend a lot of time with lengthy paperwork.
In contrast, think about a time when a company offered you a rebate when you purchased a product or service. Completing the many steps required to receive the rebate probably reduced the pleasure or satisfaction of saving that amount of money. Or remember the last time you spent five minutes in an automated telephone system trying to figure out how to get connected to a human customer-service agent.
You need to determine if a business has a customer-service-oriented culture. It is important because customers are not loyal to those businesses with poor customer service. One study recently found that 40 percent of customers who have bad experiences stop doing business with the company.5
Find out if the business solves customer problems quickly and easily. You can do this by learning whether a business gives its customer service agents enough authority to solve customer issues or whether customers have to go through a bureaucracy to get their problems solved. Does the business hire knowledgeable employees o
r does it outsource its customer service centers to other countries?
You are looking for examples either in articles written about a business or customer interviews that demonstrate the business is customer oriented. For example:
Costco Wholesale has a practice of refusing to mark up its prices on any products by more than 15 percent.6 In fact, when commodity prices began to fall on many products, Costco quickly cut its prices, whereas other retailers took advantage of the situation, keeping their prices high. CEO Jim Sinegal said, “It is easy to raise prices. It benefits you today, but will hurt you tomorrow. The practice of taking advantage of customers will eventually alienate them.”7
Southwest Airlines doesn’t charge customers to check two bags, whereas other airlines have resorted to charging for bags to offset reductions in revenue. This policy has helped Southwest Airlines increase its customer loads and revenues per seat as customers have moved to Southwest from other airlines.8
Two other great resources are the J.D. Power & Associates customer satisfaction rankings and the American Customer Satisfaction Index (ACSI), developed by the University of Michigan National Quality Research Center. The ACSI measures the customer satisfaction with goods and services purchased from about 200 companies in more than 40 industries, along with some public sector organizations as well. It is based on interviews with more than 65,000 U.S. consumers each year, and it covers a big chunk of the total goods and services produced and imported. In fact, the University of Michigan National Quality Research Center estimates that the organizations it studies produce 43 percent of U.S. gross domestic product (GDP).
Some of the findings from their analysis of more than 16 years of data are that customer satisfaction is a leading indicator of company financial performance, and many of the companies with high customer-satisfaction scores produce higher stock returns than the S&P 500 index. Furthermore, they’ve found that the cash flows of businesses that rate high on customer service are less volatile than other businesses.9
How Does Management Stay Close to Customers?
You can evaluate how customer oriented a business is by observing how management maintains its connection to customers. The further management gets from understanding their customers’ needs at a business, the higher the probability the business will fail.
Read the biographies from the proxy statements to determine how long the CEO or top executive officers have served a particular customer base. For example, Cisco’s CEO John Chambers rose through the company ranks in customer-facing functions; as a result, he understands the importance of the customer experience. If he had instead risen through the finance, engineering, or manufacturing departments, then it is likely he would not place as much weight on the customer experience.
John Mackey, founder and co-CEO of Whole Foods Market, and Dave and Sherry Gold, co-founders of 99 Cent Only Stores, are both natural customers of their respective businesses. Mackey founded an organic grocery store because he liked to eat organic food, and Dave and Sherry Gold co-founded a discount retailer because they always liked to find bargains.
Here are a few examples of how CEOs stay close to their customers. Look for similar examples at the business you are analyzing:
Jim Cabela, co-founder of hunting and outdoor retail chain Cabelas, stays close to customers by personally reading all of the customer comment cards sent to headquarters from each of the stores. He then follows up on the customer comments with the appropriate manager or employee of the store.10
Howard Lester, who bought Williams-Sonoma (an upscale housewares and furniture retailer) in 1978, is another CEO who reads every customer letter and comment card. Lester did not measure the success of the business solely on metrics such as inventory turns, but instead on customer metrics, such as “How many customers did we fail to satisfy yesterday?”11
Finally, here are a few examples of how a business remains close to customers and attempts to view the products from the customer perspective. You will often see articles written about how businesses stay close to customers. Here are a couple of examples of the kind of detail you will find in case studies or other articles:
At Procter & Gamble, the managers who were responsible for the Max Factor and Cover Girl brands spent a week living on the budget of a low-income consumer. This gave the managers insight into the lives of these customers, especially how they budget to purchase personal items.12
Intuit, the tax-preparation-software company, often studies customers actually using their products at home or work to learn more about how they really use it.13
12. What pain does the business alleviate for the customer?
One of the most common questions venture capitalists ask a prospective start-up is, “What pain does your business alleviate?” The venture capitalists want to understand what problems the entrepreneurs are solving and what customer needs the business is filling. If a business does not fill a need or solve a customer’s problems, then it will fail. Here are two examples of companies that solve a particular customer problem:
Stericycle, a medical waste disposal company, helps physicians and other medical providers avoid potential liabilities that come from the disposal of medical syringes and other medical waste.
ADP, a payroll and human resource management provider, eliminates the needs to hire in-house employees to handle payroll administration.
Just as these businesses are solving customer problems, you need to identify the problems that are being solved by the businesses you are analyzing.
13. To what degree is the customer dependent on the products or services from the business?
To answer this question, you need to determine if the product or service is “need to have” or “nice to have” for the customer. The more a customer needs to have a product or service, the less the earnings of a business will fluctuate. The more discretionary a product or service is, the more earnings will fluctuate.
A business whose customers depend on the product or service has a significant advantage. Think of this as a continuum:
Need to have. On one extreme are products manufactured by Medtronic, which builds medical devices that people literally can’t live without, such as implantable pacemakers.
Need to have, but not immediately. In the middle are products or services that can be deferred but at some point need to be purchased, such as car maintenance. After all, if you don’t change the oil in your car, the motor will eventually fail.
Nice to have, but not critical. At the other extreme are discretionary products and services, on which customers are less dependent. These items are products or services that a consumer can defer purchasing for a long time (and may not even purchase at all), such as jewelry, a new car, a new house, or travel.
Do not make the assumption that a discretionary business or industry will always lose sales in tough times, however. For example, many luxury retailers—such as Louis Vuitton Moët Hennessy or Compagnie Financière Richemont SA, which owns Cartier, Montblanc, Alfred Dunhill, and Van Cleef & Arpels—were thought to be sensitive to business cycles, and their stock prices fell when the recession began in 2007. However, the stock prices of these two companies quickly rebounded as their core customers, who are ultra-wealthy, continued their spending habits, and sales did not drop as much as was anticipated.
14. If the business disappeared tomorrow, what impact would this have on the customer base?
To understand how much customers depend on a business, ask what the customer would do if the business disappeared tomorrow. Think about what you would do if your favorite retailer disappeared. Where else could you go and why? Is it easy to find alternatives?
For example, when I interviewed customers of ratings firms Moody’s and Standard & Poor’s, I spoke with customers ranging from insurance bond departments to hedge funds, and I asked them what they would do if the ratings agencies disappeared tomorrow. Most answered that they would have an extremely difficult time buying new bonds and that it would severely disrupt their daily life. In
other words, most of the customers were dependent on the service these ratings firms provide.
Key Points to Keep in Mind
The quality of a business is determined by the quality of its customers.
One of the main pitfalls in researching a business lies in viewing the business from your own perspective, instead of viewing the business from the customer perspective.
A business that earns its revenues from a diversified customer base has less risk than one with a concentrated customer base.
The more frequently a business interacts with customers, the more critical it is for it to have high customer satisfaction. You can learn if a business has a customer-oriented culture through research studies produced by J.D. Power & Associates or the American Customer Satisfaction Index (ACSI).
If a business is out of touch with customers, or is failing to meet their needs or solve their problems, it will eventually fail.
The more a customer needs to have a product or service, the less the earnings of a business will fluctuate. To understand how much customers depend on a business, ask what customers would do if the business disappeared tomorrow.
1. Boyle, Matthew, Susan M. Kaufman, and Joan L. Levinstein, “Best Buy’s Giant Gamble.” Fortune, April 3, 2006.
2. Porter, Michael. “The Five Competitive Forces That Shape Strategy.” Harvard Business Review, January 2008.
3. Talley, Karen. “Retailers, Suppliers Tussle.” Wall Street Journal, February 11, 2009.
4. Rohwedder, Cecilie. “Store of Knowledge.” Wall Street Journal, June 6, 2006.
5. Dougherty, Dave, and Ajay Murthy. “What Service Customers Really Want.” Harvard Business Review, September 2009.
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