Risky Companies That Lack Diversification

Rupert is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

Any investor will tell you that the key to long-term sustainable investment returns is through diversification. Diversification through stocks is one thing, but companies that are not diversified themselves are another.

Companies that rely on only one production facility, one product or, one product line are exposing themselves to significant risks, such as the loss of a production facility, or boycotts and changing trends, all of which can quickly erase revenue and profits.

One production plant producing explosive fertilizer

Fertilizer producer Terra Nitrogen (NYSE: TNH) only has one production facility and this poses some serious risks. Indeed, the company notes within its annual report that the facility faces risks from terrorism, regulations to combat terrorism (fertilizer can be used to manufacture explosive devises), reliance on third-party transportation providers, the volatility of natural-gas prices in the US, weather conditions, health and safety regulations and/or emission/environmental requirements and finally, cyber-attacks.

Obviously, these risks are not just limited to Terra Nitrogen. However, as Terra only has one production facility, these risks are compounded. Where a company would usually have other production facilities to take over if one was shut down for any of the reasons above, Terra would lose all of its production capacity and revenue stream.

That said, Terra has attempted to diversify away, leasing some of its facilities to other operators. As of January, the company had leased two storage terminals on contracts lasting five years for $400,000 annually subject to an annual inflation adjustment. Terra also has a number of its rail cars under lease for market-based rental payments of $3,600 per car per year. The leasing revenue accounts for less than 0.2% of total revenue but does provide some concrete recurring income for the company.

Additionally, with only one production facility, Terra is not able to achieve strong economies of scale that other producers may be able to.

Lastly, as a master limited partnership, Terra faces risks from its relationship with CF Industries, as CF controls the company's general partner, which could pose some conflicts of interest regarding management.

A single refinery means a lot of risk

Northern Tier Energy (NYSE: NTI)  is a very lucrative company. Unfortunately, the majority of its income is dependent upon one refinery located in St. Paul Park, Minn. This exposes the company to a huge risk of a shutdown from similar threats that affect Terra; terrorism, cyber security, environmental issues, reliance on third-party providers and issues relating to the structure of a master limited partnership. However, there is another significant threat that is overshadowing Northern Tier, and that is the company's retail division, which should provide some diversification but due to high fixed costs is dragging the company down.

Northern Tier operates 166 convenience stores and supports 73 franchised convenience stores. During Q1 of this year, revenue from the company's retail segment was $75.8 million with a gross margin of 37%. However, direct operating expenses cost the company $34.6 million. So, Northern Tier's retail segment made a profit of only $600,000, a net margin of 0.8%. (The retail segment generated a loss during Q1 2012.)

More than 90% of Nothern Tier's Q1 EBITDA came from its refinery, and with such an over-reliance on one asset the company is highly exposed to a number of risks going forward.

One product that is under scrutiny by the FDA

Monster Beverage's (NASDAQ: MNST) main product is energy drinks. Unfortunately, this means the company is subject to fashion trends, a highly competitive marketplace and recently, scrutiny from health and safety bodies around the world.

Monster is facing almost constant scrutiny from the FDA. It was recently forced to re-brand its drinks from 'dietary supplements', which avoided some FDA restrictions, to 'beverages'. The new designation allows the company not to reveal any deaths by ailments associated with the products to the FDA - this could be a huge stumbling block as it indicates that the company is trying to hide something. 

In addition, Monster has also been protecting its name in other ways, holding a news conference after being associated with the death of a 14-year-old girl. The company threatened to take a dietitian to court for spreading information relating to child deaths to the consumption of high-caffeine drinks. Furthermore, Monster has filed a lawsuit in an attempt to halt San Francisco City Attorney Dennis Herrera's investigation into the company's marketing tactics. Monster has accused authorities of singling out the company - after all, any child can walk into Starbucks and buy one or more coffees. 

To the pessimist, all of these activities suggest that Monster has something to hide.

And it would appear that the FDA agrees. The administration has launched a formal investigation into added caffeine in food products, in particular, the effect on children.

As Monster has no diversification outside of high-caffeine drinks, the company would lose 100% of its revenue almost overnight if a ban came into force.

That said, a more positive view could be taken. Indeed, it is highly unlikely that the FDA will ban high-caffeine drinks. Instead, limitations may be placed on size (age limitations are unlikely). Regulation on the size of drinks could work in Monster's favor, as smaller products mean higher margins. If the whole industry is regulated, then the company will not have to compete with peers for the best value for money. Instead, the company can pocket higher profit margins, generate a better return on equity and give more cash back to shareholders; that’s the optimistic view anyway.

Foolish summary

Overall, these companies are not for the risk averse as their lack of diversification makes them highly susceptible to any number of risks.

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Fool contributor Rupert Hargreaves owns shares of NORTHERN TIER ENERGY LLC. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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