high fixed cost businesses
The most common and the most powerful type of operating leverage is present in companies with high fixed costs, or so-called capital intensive businesses.
(An aside: Traditionally, the need to spend immense amounts of money on plant and equipment to be able to enter a business served as a big barrier against new competitors. The major threat to the capital intensive firm is technological change.
Over the last forty years or so, change has been so rapid that capital intensity has suddenly turn into a millstone in many industries (think: Best Buy vs Amazon in retail). Nevertheless, there are still many capital intensive businesses that remain attractive.)
Take a hotel as an example
How much do you think the out-of-pocket cost is for a hotel company to lodge a guest for one night?
It’s the cost of cleaning the room, changing the sheets and putting in new soaps. Less than $20. But the guest can easily pay $100 or $200 a night (in NYC, it’s more like $500) for his stay.
Having an “extra” (other jargony terms used: marginal, incremental) guest in the hotel is almost pure profit. After all, the hotel is open and staff are present, whether or not our guest is. In practical terms, those costs are fixed.
Take an airline (please!)
Airlines have been a dreadful business for longer than I’ve been an analyst. Same question, though. How much extra does it cost the airline to service one more passenger who is paying $5,000 in first class for an international flight?
It’s the cost of the meal(s). The plane and the crew are going to be there whether our incremental passenger is on the flight or not. So, again, he’s almost pure profit.
The trick with a capital intensive business is to sell at least enough of your product or service to cover your fixed costs. The rule of thumb in the hotel business is that at 50% occupancy, you’re not making profits but are at cash flow breakeven (meaning you’re meeting all your out-of-pocket costs). At 60%, you’re barely profitable. At 70%, you’re making wheelbarrows full of money.
WSJ on airlines
Same thing with airlines. Only the story here is a lot grimmer. The Wall Street Journal had a really, really good article in June about air carriers’ cost structure, that was based on research by Oliver Wyman. It concluded that on a 100-seat aircraft, the airline has to fill 99 to break even. The carrier’s profits come from filling that last seat, where someone gets shoehorned in right next to the restrooms.
Think about it, though. If the airline in the WSJ example could somehow scrunch the seats an inch and a half closer together, it might be able to fit in an extra row. Assuming customers didn’t revolt, revenue would go up by 4% from the four extra passengers. But profit would go up almost 5x!!!
That’s operating leverage.
don’t use percentages in analysis
If I have one criticism of the diagram “Decoding A Flight” in the article, it’s that it uses percentages, not actual figures.
I understand that this is the best (probably the only) way to illustrate the article’s point. From years teaching securities analysis, however, I have a different perspective. If you take the percentages shown and apply them to, say, a different airline or a bigger plane, profits will always be 1% of sales. It’s because you’re using margin percentages, not the raw data. Using percentages obscures operating leverage.
The article also gives a useful illustration of what securities analysts do all day. They try to figure out, in as much detail as possible, the profit structure of the companies they follow.
a simple model
Let’s make up a company. It builds a factory and puts machinery in it, at a cost of $40 million. Assuming that everything will last for 40 years, each year the firm will enter a (non-cash–it has already spent the money) charge of $1 million on its income statement to represent recovery of this outlay.
That’s $250,000 each quarter.
Let’s say the company has a factory payroll of $100,000 each quarter. So total costs are $350,000.
Finally, suppose the firm makes some item that uses $10 of raw materials and can be sold for $80. That means each item earns an operating profit of $70.
Case 1. The company breaks even in a quarter if it sells 5000 items.
Case 2. What if it sells 4500?
Then sales are: $360,000
Costs are: $350,000 + ($10 x 4500) = $395,000
Case 3. If it sells 6000, sales are $480,000 and profits are $70,000.
Case 4. If it sells 7000, sales are $560,000, 16.7% higher than in case 3. But profits are $140,000, or double those of case 3.
That’s operating leverage.
how do we find out what a company’s costs are?
Avenues to explore:
–the company’s 10-k, annual report and website
–the company’s investor relations department
–the industry trade association
–the financial press–you might be incredibly lucky and see an article like the airline
–sell-side research, although most analysts don’t publish their detailed spreadsheets for fear their rivals will “borrow” the results.
Two other thoughts:
–look for a small company in the industry you’re interested in. The firm’s structure might be simpler and more visible than is the case with a larger firm. The small company’s IR department may be more willing to talk to investors, too.
—a quick and dirty approach. If the company is highly seasonal, figure out the extra sales in the high revenue quarter and compare it with the extra profit those sales bring with them. Sometimes, a year-on-year or quarter-on-quarter comparison can also yield useful information.