United (UAL) and overbooking


Overbooking itself is an airline industry staple.  It’s also a sensible practice.

That’s partly because there’s always someone who doesn’t show up for a flight.  For example, business people who travel often may book seats on three or four different flights to their next destination on a given day.  No matter what time their morning client meeting ends they’ll be able to get away easily.  They just cancel the ones they won’t use as the day develops.

operating leverage = large profit for the last seats sold

A plane that takes off with unused seats is a lost revenue opportunity.  Like unused hotel rooms, there’s no way to sell them later on.  And both hotels and airlines have a ton of operating leverage–there’s maybe $10 in marginal cost associated with an incremental seat/room.  So the profit contribution left on the table from non-use is immense.

UAL’s overbooking algorithm

I’ve noticed with UAL, which I’ve used regularly for years, that all of the last half-dozen or so flights I’ve been on recently have been overbooked.  That’s after seeing maybe one overbooked flight in the prior year.

My (unscientific) guess is that UAL tweaked its overbooking algorithm a few months ago in an effort to squeeze a bit more profit out of its flights.

My experience is that when companies begin to operate by trying to figure out where the the line is that marks the minimum a customer will accept–and then tries to get as close to that line as possible without crossing it, disaster inevitably happens.

I first encountered this phenomenon with a former management at Marriott that later went on to wreak havoc at Disney and at Northwest Air.  Their idea was that no one would notice if they lowered the room ceilings on newly-constructed hotels by an inch or two and shrank the room square footage by, say, 5%.  Yes, construction costs were a bit lower.  But I remember those rooms as being vaguely unsettling when I entered.  Business customers, the heart of a hotel chain’s profits, fled in droves.

If I’m correct, the remedy for UAL is simple.  Just go back to the former algorithm.  If, however, the corporate culture at UAL is to provide customers with the minimum acceptable service–and, to be clear, I don’t know that it is–more trouble is likely brewing.


the Intel (INTC) 3Q12 preannouncement: studying operating leverage

the preannouncement

As I wrote about yesterday, INTC preannounced weaker than expected 3Q12 earnings.  The main culprit?  …worldwide general economic slowdown.

The company said it now expects revenues of $13.2 billion for the quarter, down by 7.7% from the $14.3 billion it guided to when it announced 2Q12 earnings two months ago.  The gross margin will come in at 62% instead of 63%.  Virtually all other cost items will remain the same.

looking at leverage

This isn’t much data.  But it’s enough for us to see two things about the company, manufacturing leverage and leverage on SG&A (Selling, General and Administrative) expenses.

manufacturing leverage

two kinds of costs

In the simplest terms, in every accounting period employees get paid and the accountants apportion costs for the use of the factory and the machinery in it, whether or not anything gets build.  So, in a sense these are indirect costs of manufacturing.  In the short run, they’re relatively fixed.

In addition, there’s the cost of the materials–electricity, gas, silicon, who knows what else–that get used up in making INTC chips.  These are direct costs.   Their total in any period is variable, depending on how many chips get made.

Accountants assign each chip a total cost that depends on two factors:  the out-of-pocket cash (variable cost) spent making it plus its share of indirect costs, a figure that depends on how busy the factories are.

gross margin

Total cost ÷ sales price = gross margin.

separating the two

Is there a way to find out how much of the total cost is variable and how much depends on how well sales are going in a given quarter?  In INTC’s case, yes.

Management has just told us that sales will be $1.1 billion less than anticipated and that this fact will lower the gross margin by a percentage point.  That’s not because the variable cost of making a chip has changed; it’s because the indirect (or fixed, or overhead) costs of running the factories are being distributed over a smaller number of chips.  (It’s a little more complicated than that, but not a worry in this case.)

Another way of saying this is that in order to get to the new, lower, sales and operating profit estimates, INTC has subtracted the sales price of the extra chips it won’t sell and only the variable cost of making those chips.  If we calculate the change in estimated gross profit and divide by the change in sales, we’ll get a variable cost margin for those “extra” chips.

Here we go:

$13.2 billion x .62  =  $8.18 billion in gross profit

$14.3 billion x .63  =  $9.01 billion in gross profit

The difference is $.83 billion, the gross profit lost from lower sales.   This gross profit   ÷ $1.1 billion in lost sales   =  75.5%.

Therefore, 75.5% is the profit margin from producing/selling an extra chip during the quarter.  That’s the manufacturing leverage INTC gets at current production levels for getting/losing additional sales.

Note, too, that the new operating profit is 9.1% less than the original estimate.  That compares with a 7.7% drop in sales.  So, while there is operating leverage in the manufacturing operation, but at current production levels it’s not huge.

SG&A leverage

INTC has two types of SG&A.  One is R&D.  The other is the typical SG&A that any industrial company has. The two items are roughly equal in size.  This quarter they’ll amount to $4.6 billion.

Let’s subtract that from both the original gross profit estimate and the new guidance.

$8.18 billion  –  $4.6 billion  =  $3.58 billion in operating income

$9.01 billion  –  $4.6 billion  =  $4.41 billion in operating income

Now calculate the percentage drop in operating income that our 7.7% decline in sales produces.

It’s 18.8%!

To recap, the 7.7% fall in sales produces a 9.1% drop in gross profits and an 18.8% contraction in operating profits.  Of the 11.1 percentage point differential, 1.4 comes from the manufacturing process, 9.7 from SG&A leverage.

In other words, the operating leverage at INTC is coming from SG&A, not manufacturing.  If INTC wanted to reduce costs in a way that would affect current reported profits the most, it would attack either R&D or “normal” SG&A.

operating leverage (III)

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)

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

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.