Category Archives: operating leverage

operating leverage (III)

August 29, 2012 By in Accounting, growth vs value, operating leverage, working capital Tags: , , , , , , Leave a comment

You may notice that I’m working my way down the income statement in discussing operating leverage.  Yesterday I wrote about the leverage that comes from product manufacturing.  The key to finding this leverage is identifying fixed costs.

All the profit action takes place between the sales and gross profit lines.  This is also the most important place to look for operating leverage for most firms.

operating leverage in SG&A

Today’s topic is the operating leverage that occurs in the Sales, General and Administrative (SG&A) section of the income statement.

The general idea is that large parts of SG&A expense rise in line with inflation, not sales.  So if a company is growing at 10% a year while inflation is 2%, SG&A should slowly but surely shrink in relative terms.  And the company will have an additional force making profits grow faster than sales.

For many non-manufacturing companies, this is the major source of operating leverage.

why this leverage happens

There are several reasons for SG&A leverage:

–most administrative support functions reside in cost centers, meaning their management objective is to keep expenses in check.  Employees here are not directly involved in generating profits, so they have no reason to demand that their pay rise as fast as sales.

–as a company gets bigger and gains more experience, it will usually change the mix of administrative tasks it performs in-house and those it outsources, in a way that lowers overall expense.

–a small company, especially in a retail-oriented business, may initially do a lot of advertising to establish its brand name.  As it becomes larger and better-known, it may begin to qualify for media discounts and be able to afford more effective types of advertising.  At the same time, it will be able to rely increasingly on word-of-mouth to gain new customers.  In addition, it will also doubtless be shifting to more-effective, lower-cost internet/social media methods to spread its message.

negative working capital

Strictly speaking, this isn’t a form of operating leverage.  It has its effect on the interest expense line.  And in today’s near-zero short-term rate environment, it’s not as important as it normally is.  But, on the other hand, one day we’ll be back to normal–when being in a negative working capital situation will be more important.  It’s also one of my favorite concepts.

If a company can collect money from customers before it has to pay its suppliers, it can collect a financial “float” that it can earn interest on.  The higher sales grow, the bigger the amount of the float.  If the company is big enough (or, sometimes, crazy enough) it can even use a portion of the float to fund capital expenditures.  The risk is that the float is only there if sales are flat or rising.  If sales begin to decline, either because of a cyclical economic downturn or some more serious problem, the float begins to evaporate, as payments to suppliers exceed the cash inflow from customers.

Lots of businesses are like this.  For example, you eat at a restaurant.  You pay cash.  But the restaurant only pays employees and suppliers every two weeks.  And it pays is utility bills at the end of the month.

Hotels are the same way.  Utility companies, too.  Amazon and Dell, as well.

operating leverage (II)

August 28, 2012 By in growth vs value, operating leverage Tags: , , , , , , Leave a comment

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

Loss:  $35,000.

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

–trade publications

–government offices

–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.

More tomorrow.

 

 

 

 

 

operating leverage: what it is and how to look for it

August 27, 2012 By in operating leverage Tags: , , , , , , , Leave a comment

operating leverage may be the key to stock selection

In my judgment, and given my growth-oriented way of looking at stocks, I think that operating leverage is the second-most important idea for potential investors in a company to understand.

(The first-most important concept is to make sure that the company is, and will remain, an economically viable entity–and that all shareholders will share in the profits the firm makes.  This isn’t usually a pressing issue for mid- and large-cap stocks in the US.  And it doesn’t take much time.  You can check out financial stability quickly in a service like Value Line–although you’re always better off looking at the financials yourself.  You have to be aware of the credit facts, in case that great start-up you own will likely run out of money before it can get a product to market.)

a key source of earnings surprise 

After you’ve put the issue of whether the company will survive behind you, the crucial issue for growth investors is the possibility of positive earnings surprise.  This means the chance that a firm’s profits will be growing faster than the market expects, for longer than the market expects.

That’s where operating leverage comes in.

what operating leverage is

Operating leverage is the idea that a company’s operating profits can rise and fall more rapidly than sales.  How can this happen?  I’ll go into detail in the next couple of posts, but the general concept is an easy one.

A company’s costs general fall into one of two categories:  variable or fixed.  Variable costs are those directly connected with the creation of the product or service sold.  Fixed costs are everything else.

In the world of manufacturing, where these distinctions were first made, variable costs are mainly the raw materials used in producing a product and the labor costs of the workers directly involved in making it.  Fixed costs are those that the company runs up whether it generates any output or not.

Fixed costs themselves are usually divided into two types:

–production related, like the salary of the plant manager, and the costs of building/leasing the factory and buying/renting the machinery in it; and

–SG&A, or Sales, General and Administrative.  These latter include the chairman’s compensation, as well as that of all others at corporate headquarters, plus the advertising/promotion budget and the cost of a salesforce.

variable vs. fixed–shades of gray

Yes, these are somewhat fuzzy concepts.  For instance, in return for a lower price, companies may have purchase contracts for raw materials that require them to pay for minimum deliveries, whether they take them or not.  Workers may also have employment contracts.  In neither case are expenses as “variable” as they might seem.  On the other hand, the firm’s salesforce and top management may be paid mostly in bonuses based mostly on sales/profit growth.  So these costs aren’t very “fixed.”

Still, such cases normally make only minor differences in a firm’s total results.

financial leverage is something else

Of course, there’s also another form of leverage a company may employ–financial leverage, which I’ve discussed in my recent post on return on capital vs. return on equity.

More tomorrow.