Case 040Corporate credit and ratingsCore
A fast-growing software company gets most of its revenue from five clients. Assess its competitive advantage and barriers to entry, and test whether its growth survives the loss of its largest client.
1The situation
Nexavo Software builds and runs core operations software for mid-sized insurers. Revenue has grown 25% a year for three years, from about Rs 307 crore to Rs 600 crore. Its top five clients provide 62% of revenue, and the largest alone provides 20%.
Annual client churn, the share of clients that leave each year, is 8%. Contracts run three to five years, and switching away means re-integrating the software with a client's policy, claims and accounting systems, which clients describe as a year-long project. Management's plan assumes another 25% next year.
2Your task
What protects Nexavo's revenue, how exposed is it to one client, and is 25% growth sustainable from here?
Quick check
If the largest client leaves at the start of next year and everything else goes to plan, what is next year's growth?
Worked solution
Try it on paper, then open one step at a time.
30-second answerThe answer to give first
Nexavo has a real moat in switching costs, but its growth rests on a few clients: losing the largest would cut next year's growth from 25% to about 5%. Rs 120 crore of lost revenue wipes out 80% of the Rs 150 crore the plan adds. With 8% yearly churn, there is about a one in three chance that at least one top-five client leaves in any year. The business is defensible; the growth forecast is fragile, and a lender should price the concentration.
Step 1What protects Nexavo's revenue?
Changing your bank is a nuisance; changing the software that runs an insurer's policies and claims is a year of work and risk. Switching costsThe money, time and risk a customer bears to move to a competitor. High switching costs keep customers even when a rival is a little cheaper. are Nexavo's main competitive advantage, and they show in the numbers: 8% churn means the average client stays about 12 years. The barrier to entry for a rival is similar: it must win a client who faces the same year-long migration, so it needs a clearly better product, not a slightly cheaper one.
Step 2How exposed is Nexavo to one client?
A food stall outside a single office building does well until the office moves. Nexavo's largest client is Rs 120 crore, 20% of revenue, and the top five are Rs 372 crore, 62%. If the largest leaves at the start of next year and every other part of the plan holds, revenue is 600 less 120 plus 150, Rs 630 crore: growth of 5% instead of 25%. That is optimistic, since the plan's growth probably included some expansion at that client.
Step 3How likely is that, and what does churn really mean here?
Low churn is reassuring on average and misleading at the top. If each client has an 8% chance of leaving in a year, the chance that at least one of the top five leaves is 1 minus 0.92 to the fifth power, about 34%. Over the next three years the largest client alone has about a 22% chance of leaving. Contract dates sharpen this: a large client whose contract renews next year is a live risk; one locked in for four more years is not. Ask for the renewal calendar by client.
Step 4Is 25% growth sustainable from here?
Each year 25% means more new revenue than the year before: Rs 150 crore next year against about Rs 77 crore three years ago. That needs a steady flow of new mid-sized insurers, and the pool of such clients in one market is finite. Ask how much of past growth came from existing clients buying more, net revenue retention, and how much from new names. A credit view: the franchise supports the debt; the concentration argues for tighter terms, such as a covenant tied to the loss of a major client, and for sizing debt on revenue without the largest client.
Where candidates lose it
The usual miss is to praise the growth rate and the low churn and stop there. Churn is an average; the credit question is what happens when one of the few big clients leaves, and here that single event erases most of a year's growth.
The second is to treat concentration as fatal. High switching costs make each big client stickier than average, so the balanced answer weighs the moat against the concentration rather than choosing one.
What the interviewer asks next
- What contract terms would you look for to judge how locked in the largest client is?
- How would you size a loan to Nexavo so it survives the loss of its largest client?
- Which metric would best show whether growth is coming from new clients or existing ones?
Asked at Morningstar, Equity Research, Anonymous interview candidate in, 2023 (Wall Street Oasis): Do they have any barriers to entry? Are they able to sustain their revenue growth?
Company names and figures are illustrative.