calculating operating leverage

I’ve written a number of posts on operating leverage.  You can use the search function on the blog to get them.

The basic idea is that a company has both fixed costs, which it must pay whether it sells anything or not, and variable costs, which are a function of the number of things a company sells.  Once a company covers its fixed costs through sales, the operating profit on additional sales can be very high.  This is a key source of positive–and negative–earnings surprise.

As a practical matter, though, how can we calculate how operating leverage works in a given company?

For some firms, it’s impossible.   Take 3M (MMM).  It makes a gazillion different items, many of them sold in massive quantities. For an investor, there’s no way to see very deeply inside the company.

We also have to realize that the data we get from any company’s financials is going to be imperfect, at the very least during our initial look.  If we take the time and energy to compare our projections to the actuals the company publishes, listen very carefully during management conference calls for clues, and call the company every once in a while, we may be able to refine the numbers we come up with in a surprisingly significant way.

Nevertheless, for smaller companies that sell only one or two main products, there’s a very simple way to get an idea of whether a firm has significant operating leverage or not:

–take two most recent consecutive quarters

–subtract the revenue reported for Q1 from the revenue reported from Q2

–subtract the operating income of Q1 from that of Q2

–calculate an incremental operating margin by dividing the operating income change by the sales change

–compare that with the operating margin achieved during either quarter.

An example:

Harley-Davidson (HOG–I own shares, despite the fact the ticker symbol spells a word) sells motorcycles, spare parts and branded merchandise.

During 2Q13, the company posted motorcycle-related revenues of $1.631 billion and operating profit of $362.9 million.  The operating margin was 22.2%.

During 1Q13, HOG had motorcycle revenues of $1.414 billion and operating profit of $279.0 million.  The operating margin was 19.8%.

The quarter-on-quarter revenue difference was $217.9 million, and the q-on-q operating profit difference was $83.1 million.  The operating margin on the extra production was 38.1%.

In HOG’s case, we can go on to make a number of refinements.  We can try to separate out the profits from sales of merchandise and spare parts, which are relatively small in revenue in comparison with motorcycles but which carry higher margins.  And we can examine whether the much higher margin on incremental sales comes from manufacturing efficiency or from leveraging SG&A (it’s the latter).

But the main point is clear.  HOG makes almost twice as much on incremental sales as it does on average sales.  And we found this out just by making some simple subtractions.


good news from Harley Davidson

the results

Harley Davidson (HOG) reported 2Q11 earnings before the New York market opened on July 19th.  EPS came in at $.81, a gain of 37% year on year, on revenues that were up by 18%, at $1339.7 million.  The Wall Street analyst consensus for HOG was $.71.

In contrast to most of the companies I’ve been watching, whose stocks have either shown little positive reaction–or gone down–after big positive earnings surprises (look at WYNN or AAPL), HOG shot up about 9% on this news, capping a run that has seen the stock rise 50% since mid-June.

the turnaround

HOG is an intriguing turnaround story, with three elements to new management’s plans:

–recovery from very serious damage done by the recession

–broadening the customer base beyond American males who watched Easy Rider as a first-run film, secretly love the Grateful Dead and need the extra stretch HOG puts in its tee shirts to accommodate seriously expanded waistlines, and

–overhauling inefficient manufacturing and distribution.

I’m not sure that at today’s price you’ll make a lot of near-term money in the stock.  I don’t own HOG now, though I owned it for years in a small-cap portfolio I once ran (despite the fact that I consider a US company having a ticker symbol that spells a word to be a serious red flag).  I did think about buying the stock after good 1Q11 results, but decided I had enough risk in my personal portfolio without it.

Anyway, what interests me most about HOG’s 2Q earnings report is what it says about the current state of the US economy.

a little history

Like a motor boat, or a two-seater sports car, a motorcycle–especially an expensive one like a Harley–is not a very practical purchase.  The riding season is short in many parts of the country and rainy weather turns a ride into an unpleasant experience for most people.  Sales of any of these vehicles are highly sensitive to the state of the economy.

During the boom years in the middle of the last decade, lots of people were feeling wealthy enough to buy Harleys.  Many got financing from HOG.  As the recession developed, a large number of these new owners couldn’t afford their payments any more and turned the keys back over to Harley.  This had two bad consequences for HOG:  demand for new bikes dried up; and dealers’ lots were flooded with tons of repossessed next-to-new used motorcycles that needed heavy discounting to be resold.  That depressed prices across the board.

Pretty ugly.

the sound of a corner turning

What caught my eye about HOG’s 2Q11 earnings report is that, for the first time since late 2006, retail sales of new motorcycles are up year on year in the US–by 7.5%.  Dealer inventories are below normal.  The credit experience in HOG’s financing arm has been improving for four quarters–although this is probably mostly a function of better underwriting.  And the company has raised its projected shipment numbers for the second half.

This is certainly welcome news for HOG.  More important to me, the increase in demand for new motorcycles seems to show that consumers are more confident, and that therefore the US economy is on a sounder footing, than the consensus realizes.



Harley Davidson (HOG) as economic barometer–positive signs

Harley Davidson (HOG) is an iconic American company. Harley Davidson motorcycles have typically been an aspirational purchase for men over 35 (maybe 50+ and having gray hair might be a more accurate characterization). They carry echoes of Easy Rider, The Grateful Dead, and the Sixties Generation, as well as a hint of the power/danger of the biker gangs whose staple ride they are.

HOG is a particularly interesting company operationally, in my opinion. It is trying, with some success, to broaden its image to appeal to younger riders, women and minority group members. The company is also rationalizing its manufacturing operations and gaining better control over the workings of HDFS, its credit arm. All these moving parts present opportunities for a careful researcher to find evidence of potential positive earnings surprise.

And, of course, Warren Buffett, himself an icon, has recently become a significant shareholder.

In this post, however, I’m more interested in HOG as an economic indicator than as a stock to buy. Motorcycles are perhaps the ultimate discretionary (read: frivolous or unnecessary) durable purchase. A Harley may cost $20,000 and, though it may be a joy to ride, it’s not particularly useful. Boats probably top the list for frivolity, but they don’t appeal to as wide a demographic as bikes. (I own a small runabout and a couple of Harley t-shirts, but no bike—so far.)

HOG reported its June quarter results yesterday morning. They contain two positive signs for the US economy.

The first positive is in domestic motorcycle sales. Although they remain at only about 60% of the pre-financial crisis level, they are up slightly year on year.


2008           -13.0%     +7.9%            -2.0%

2009          -25.8%      -3.4%            -12.8%

2010          -15.7%      11.2%            +1.3%

On the one hand, the growth in sales comes from purchases of used motorcycles. But they are sales nonetheless. And they are coming after HOG significantly tightened up the credit-granting standards of its finance subsidiary, HDFS, which makes bike purchase loans to about half of domestic Harley buyers.

Shipments of new bikes from HOG to its dealers are also up slightly in the first half.  Overall dealer inventories are down by over a third vs. this time last year, with only supplies of used bikes higher than normal.

All this is good news for HOG. For the economy, the interesting thing is that men are becoming comfortable enough about their personal financial circumstances to be starting to buy Harleys again (without fearing divorce or severe bodily harm from their wives).

The second piece of good news comes from HDFS. It concerns loss experience and loan delinquencies.

At 4.5% of outstanding loans, those with payments more than 30 days overdue is somewhat higher than Harley’s pre-recession experience (3.6% in 2Q06 and 4.4% in 2Q07), But its not that far above- and it’s lower than at this time last yea ror the year before.

Loss experience is better, as well.  The current annualized rate of 2.04% is better than in either of the past two years.  It’s also within striking distance of the 1.63% posted in the first half of 2007 and the 1.20% of the first six months of 2006.   This good performance is partly because 85% of HDFS’s loans are now prime (5%-10% higher than pre-2009), partly because used bike prices, which plunged during the worst of the financial crisis, have begun to rise again.  But it must also be in part due to the fact that money isn’t so tight as it was during the worst of the recession.

I’m of two minds about the stock.  I don’t regard the Warren Buffett endorsement as a plus.  Mr. Buffett, one of our profession’s true geniuses, saw much earlier than anyone else that brand names and established distribution networks–in other words, intangible assets–had an immense value that was neither listed on the corporate balance sheet nor a factor in the thinking of his contemporaries.  So you could in effect buy them for free.  –and that’s what Mr. Buffett did.

But the insight came almost a half-century ago.  Everybody knows it now, just as well as everyone knows about Benjamin Graham.  So the Buffett touch isn’t enough any more, in my opinion.

In the case of HOG, however, a genuine corporate turnaround appears to be underway.  More in a later post.