Category Archives: growth vs value

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.

return on equity vs. return on capital: two important indicators

August 21, 2012 By in return on equity vs. return on capital Tags: , , , , , , 1 Comment

In a post a few days ago, I wrote about return on equity,  which is a standard measurement of the skill of the management of a company whose stock we might consider owning.  Services like Value Line provide statistical arrays for companies–and for the industries they’re a part of–that have these calculations,and a bunch of others, already done.

Today I want to add an important refinement–return on capital.

two forms of capital

Corporations have two sources of investment capital available to them.  One is equity, which is ownership interests in the firm that the corporation sells to shareholders.  The other is debt.  Debt comes is two flavors:  bonds issued by the company or bank loans that the firm takes out.

Debt holders have a call on corporate cash that’s superior to shareholders’.  On the other hand, as creditors, debtholders have no ownership rights. So, other than if the firm is in dire financial condition, they have no say over corporate operations.

Why take on debt?

It’s easier to raise capital this way, under normal circumstances.  Also, Americans, if no one else, believe that debt is a cheaper form of capital–meaning that shareholders can gain extra return by using it.

On the other hand, financial leverage (which is what having debt is typically called on Wall Street) brings risks with it.  So it’s important for investors to distinguish in a potential investment’s returns the portion that comes from employing capital in the company and the part that comes from using debt.

where return on capital comes in

Return on capital measures the first; return on equity measures the first plus the second.  Subtracting return on capital from return on equity gives return on financial leverage (a term I made up; the number doesn’t have a common name), or return from capital structure/financial engineering.

a simple example

1.  Let’s assume that a company has 100 units of equity and that it’s in a business where investing that 100 creates 100 units of annual sales (these numbers aren’t realistic; their virtue is simplicity).

Let’s also say that the company will earn 20 units of earnings before interest and taxes (ebit) from those sales.   We’ll also say that the company pays tax at 35%.

The income statement looks like this:

sales       100

ebit          20

tax at 35%    (7)

net income       13.

return on equity =   net income ÷ shareholders’ funds   =   13   ÷    100   =  13%.

2.  Same company, but it has borrowed 100 units of debt capital @ 5% interest.

sales       200

ebit          40

debt interest    (5)

tax at 35%        (12.25)

net income      22.75

return on equity  =  22.75  ÷  100    =    22.75%.

A huge difference!!

defining return on capital

return on capital  = (net income + aftertax cost of debt)   ÷  (total capital, i.e. equity + debt)

The aftertax cost of debt:  in the US, and in many other places, interest expense is deductible from otherwise taxable income.  The tax break is:  interest expense times the tax rate.  The aftertax cost of debt is:  interest expense – the tax break.

In our case, the aftertax cost of debt is 5 -1.75, or 3.25.   Return on capital = ( 22.75  + 3.25)  ÷  200 =   13%.

results

In this example, the unleveraged company earns a return of 13% on its invested capital.  This is the return that the company’s management can achieve from operating the business.  This may be good or it may be bad   …depending on the industry and the competition.

The leveraged company produces the same return from the business.  But it amplifies this by 9.75% by using a lot of debt capital.  (By the way, the tax system encourages this behavior by allowing a writeoff of interest costs as a business expense.)

The important thing to recognize is that leverage alters the risk profile of the business, in two ways:

–the principal amount of the debt must eventually be repaid.  If the debt is a bank loan, it could be subject to a repayment demand on extremely short notice, and

–a downturn in sales will squeeze profits for the leveraged company more than for the unleveraged, since the interest expense remains a constant.  In my experience, the negative effects of leverage working against you are much more severe than this simple example suggests.

Return on equity (III): a tax-efficient split up

August 17, 2012 By in Dividends, double taxation, from growth to value: the life cycle, return on equity Tags: , , , , , , , , Leave a comment

double taxation of dividends
In the US, and most often, elsewhere, dividend payments to shareholders must be made from income on which domestic taxes have already been paid. Recipients pay income tax again on any dividend income they receive.
(In contrast, the IRS regards interest payments on bonds as an expense. So these payments are made from pre-tax income, and serve to lower the firm’s tax bill. No wonder some companies leverage themselves too much.)
For a mature, low growth, business that throws off cash and doesn’t have many good ways to reinvest the money, stock buy backs and dividend payments are the two common methods of returning these funds to shareholders. Personally, I think stock buy backs are almost always a scam. At the very least, they’re not a very dependable source of funds for income oriented investors. And double taxation means that a sizable chunk of the money available for distribution–just over a third, in the US–is lost to the taxman.
There has to be a better way!
For many firms, there is. It’s called a Real Estate Investment Trust ( REIT), and it’s becoming an increasingly popular corporate solution to the mature business problem.
Briefly, a REIT is a special form of corporation, somewhat akin to a mutual fund. It accepts restrictions on the kinds of activity it can take part in, and agrees to distribute virtually all the income it generates to shareholders. In return, it is exempt from corporate income tax.
Details on Monday.

return on equity: a measure of management prowess

August 15, 2012 By in book value, return on equity Tags: , , , , , , , , Leave a comment

REITS  …eventually

I want to eventually write about the attractiveness of REITs and the increasing tendency of mature companies in the US to turn themselves–or at least part of themselves–into them.  This is the first in a series of posts to lay the foundation for that discussion.

a new company, a blank slate 

Imagine that we’re forming a new company.  On Day 1, the books and accounts of the new firm are just empty pages.

balance sheet

Then we inject some cash to get the firm going.  We get shares of stock, representing our ownership interest in the new firm, in exchange.  The balance sheet of the new firm will reflect this transaction by recording the cash inflow on the asset side, and the same value under “shareholders’ equity” on the other (the liabilities + equity side).

income statement

The new management of our company–maybe us, maybe professionals we’ve hired–invests the cash in (we hope) high-return projects that generate a lot of income.  We, or our accountants, will periodically create an income statement to record how much money we’ve earned (or lost) during a given period of time.  In real life, the money is coming in every day and being spent or invested almost simultaneously.

where the money goes

In the simplest conceptual terms, two things can happen to the money the firm earns.  It can be reinvested in the firm’s operations, in which case we can think of it as entering the balance sheet as cash (in + or – amounts) on the asset side (and then being invested in working capital or plant and equipment, which are other categories on the asset side) and as corresponding changes to shareholders’ equity on the other.  Or it can be paid out to shareholders as dividends.

If the firm makes a new stock offering to raise additional capital, the balance sheet activity will be similar to what happened at the firm’s birth:  cash is entered on the asset side of the balance sheet; shareholders’ equity rises by the same amount on the other.

One way of summarizing this process–the one we need today–is that shareholders’ equity represents the amount of money the management of our firm has to work with:  the initial capital, the proceeds from further equity issues, plus accumulated profits (minus any amounts paid out to shareholders).

measuring management’s skill

How do we measure management success?  One straightforward method, for both actual and potential shareholders, is to look at the income the firm produces with the money it has invested.  In other words:

—       annual profit  ÷  shareholders’ equity,    which is known as return on equity.

Astute readers will recognize that shareholders’ equity is also known as book value.  Regular readers may remember that I’m not particularly a fan of book value as a valuation metric.  True, but let’s put that aside for the moment.

return on equity

The virtue of using return on equity is its simplicity.  A return on equity of 3% a year is bad.   A return on equity of 15%+ is good.  In today’s world it’s very good.

stock market adjustment

For publicly traded companies, firms that consistently achieve only a 3% return on shareholders’ equity will probably trade at a huge discount to book value.  If Wall Street believes that a firm should be able to earn 10% a year on the money it has to work with, then the 3% company might trade at 1/3 of book (in reality, the market will likely expect either the company’s board of directors or an activist outsider to force a change of management.  So the discount won’t be as deep as it otherwise should be).

On the other hand, a firm that consistently earns 15% on equity will doubtless trade at a premium.

some caveats

Bad companies can sometimes have high returns on equity.  One of my favorite examples is Fotomat, which had kiosks in mall parking lots where it collected undeveloped camera film ad returned prints to customers the next day.  I remember a shareholder calling me up one day to criticize me about my negative view, citing the company’s current 15% return on equity.  I pointed out that the prior year the company had a mammoth loss, which cut its equity in half!!  Shrinking the denominator is not the best way to achieve good return numbers.

Suppose we invested $100/share in a gold exploration venture–and our geologists discover gold worth at least $1000/share.  The stock will trade at 5x, or 10x, or some higher x, book value–even though production hasn’t started (in fact, the Wall Street cliché is that the stock peaks the day the mine opens).  Other kinds of natural resource companies can experience this phenomenon, as well.

prisoners of the past?

If we imagine the assets of a company as being a collection of investment projects–some successful, some not–how do we deal with the clunkers?  In particular, what do we do  if we’ve just been hired to run a firm and see (from low historical returns on equity) that the company is filled with terrible past investment projects?  Or how do we keep the inevitable mistakes from tarnishing our record forever?

More tomorrow.