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William J. DeRosa, Jr., CFA
William J. DeRosa, Jr., CFA

Customer Concentration Risk: LookSmart

July 12, 2010 | About:

It was back in 2004 and I happened to notice the afterhours trading on a certain stock that was moving dramatically. The stock in question was LookSmart Inc, ticker LOOK. I knew nothing about the company or whether it was worthy of investment. Nor do I mention LOOK as a investment candidate for this article. That wasn’t important back in 2004. What as relevant was that the stock was crashing over 50% - a significant decline. When a stock craters to this level, I normally follow up to understand what exactly is happening. Not necessarily because I’m interested as an investment, but rather to use as a learning tool as to what to avoid. Usually when something like this happens it is beyond the typical disappointing earnings announcement. We all know that the afterhours trading can be very illiquid and very much knee jerk reaction to news. It is the universe of traders, not investors. Many times a decline of this nature is the result of a very small biotech start-up with a one product lineup that fails a certain FDA trial stage. This was not the case with LOOK.

First, a brief description of the business: LookSmart is a search advertising network solutions company that provides search advertising capabilities to its customers. It operates in an online search advertising process serving ads that target user queries on partner sites. This was a technology company, not a biotech startup.

The following is a brief excerpt from a press clipping describing LOOK activities at the time. {LookSmart has purchased Furl.net, an Internet archiving service, in a bid to keep up with the latest innovations in Web search. LookSmart, a San Francisco-based Internet search company, suffered a major blow in the past year after losing its largest partner, Microsoft}.

LookSmart is a great example of what I consider to be a considerable risk when purchasing securities – especially true for small / microcap stocks. The risk is heavy reliance on one particular customer or partner. In this case, LOOK was heavily reliant on Microsoft for approximately 80% of their existing business. Obviously this represents a significant chunk of business. However, this type of situation is not so unusual when it comes to small companies. This can be especially true with spin-offs where the new company is reliant on the parent company for a good portion of business.

When evaluating risks in a potential investment (assuming one evaluates risk) list customer / partner concentration among them. It is good practice to run a worst case scenario analysis where that portion of business completely disappears. Assuming the company can survive, if the numbers are still compelling you have done proper due diligence. This information is clearly disclosed in a company’s 10K and is another example of the need to review the notes when reading this document.

About the author:

William J. DeRosa, Jr., CFA
William J. DeRosa, Jr. is the General Partner of Anthem Asset Management, LLC is an independent investment management company. He has also served as Director of Equity Research and Senior Portfolio Manager at various buy-side asset management firms. Mr. DeRosa is a Chartered Financial Analyst and is a member of The CFA Institute.

Rating: 4.8/5 (8 votes)


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