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The Problem With Diversification

If you've never won a big contract or huge piece of business, you don't know what you're missing. It's an incredible feeling; like a burst of adrenaline that lasts for as long as the business lasts. But that's sort of the problem with adrenaline, isn't it? When it's gone, you feel like you're dead inside. And when a company loses that one big deal, that's exactly what can happen.

At 4:05 pm EST on Monday, solid state drive maker STEC announced its third quarter results. Revenues and earnings were up considerably, beating the company's previous guidance. All good, right? Not exactly.

Buried way down in the fifth paragraph of the earnings press release, came a whopper:

"One of our customers entered into a $120 million supply agreement with us for shipments covering the second half of 2009. We recently received preliminary indications that our customer might carry inventory of our ZeusIOPS at the end of 2009 which they will use in 2010."
The next day, STEC's stock was down a whopping 39 percent on volume of 32 million shares. Turns out the customer referenced in the quote, EMC, accounted for 15 percent of STEC's revenues last year. Sure, STEC had 329 customers in 2008, but just two of them - Smart Modular and EMC - accounted for 50 percent of the company's total sales.
It's incredibly risky for a big, public company to have so few customers control so much of its business. But that problem isn't limited to big business.

When the biggest employer in the city where I live - Seagate in Scotts Valley, California - moved thousands of jobs elsewhere, it had a devastating effect on some local businesses, most notably restaurants and hotels. The same thing is happening all over the country as a result of the financial crisis.

In that case, the action of a single entity can have the same effect as that of a single, big customer.

So what's a company supposed to do to reduce its risk when one decision by one company can devastate its business? Well, some folks like to throw around "diversification" like it's a foolproof antidote to risk. But as a risk aversion strategy, diversification is no panacea. It carries its own risks. Plus there are tradeoffs and hurdles that can be insurmountable.

STEC, for example, has a relatively specialized product-line that serves a relatively narrow market. Sure, there are lots of other customers, but few as big as EMC and Smart Modular. Besides, there are competitors, too.

And while there are a number of potential products and markets the company might consider, doing so risks losing focus on its core business and customers. Combine that with additional expense, maybe some debt, lower earnings, risk of failure, and well, diversification doesn't look so great anymore.

Unfortunately, we're going to have to stop here for today. But don't worry; I'll do a follow up post that gets into some of the ways to navigate the tricky waters of diversification in the not-too-distant future. So stay tuned, okay?

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