Man­ag­ing op­er­a­tional lever­age

If a com­pany is in a po­si­tion where prof­its in­crease at a faster pace than rev­enue, it is es­sen­tial that it nav­i­gates ups and downs wisely in or­der to reap the ben­e­fits of op­er­a­tional lever­age.

Finweek English Edition - - MARKETPLACE - Ed­i­to­rial@fin­week.co.za

one of the key is­sues I look for when in­vest­ing is op­er­a­tional lever­age. Not the sort of lever­age a trader would get from us­ing de­riv­a­tives rather than buy­ing the ac­tual share – in­stead this is when prof­its in­crease at a faster pace than rev­enue.

Rev­enue growth is the top-line num­ber while profit (head­line earn­ings per share – HEPS) growth is the bot­tom-line num­ber. Op­er­a­tional lever­age, for ex­am­ple, would be rev­enue grow­ing at 15% while HEPS grows at say 25%.

The idea is that costs are largely fixed while rev­enue has flex­i­bil­ity; and an in­crease in rev­enue does not lead to sim­i­lar in­creases in costs.

In­dus­try ex­am­ples

A great ex­am­ple would be a ho­tel busi­ness. There is the base cost of own­ing and op­er­at­ing the ho­tel and, whether there are 100 or 120 guests, the base cost re­mains largely the same; the num­ber of clean­ers, re­cep­tion­ists, chefs and the like re­mains the same. Sure there is a small ex­tra cost per guest, such as soap for the bath­room, but other than those small ex­tra costs per guest pretty much all the ex­tra rev­enue from those ex­tra 20 pay­ing guests goes straight to profit (the bot­tom line). So af­ter the ho­tel reaches the break-even level of oc­cu­pancy, each ex­tra guest adds sig­nif­i­cantly to the bot­tom line.

An­other ex­am­ple would be min­ing, where costs are largely fixed. And in the case of lo­cal mines costs are in rands. So, any in­crease in the price of the com­mod­ity be­ing mined or any weak­ness in the rand ex­change rate adds to rev­enue with­out chang­ing costs and hence goes al­most di­rectly to profit.

The chal­lenge is of course keep­ing a lid on cost in­creases, while the big­ger is­sue in min­ing is that the com­pany has no con­trol over what price it sells the com­mod­ity at. Min­ing com­pa­nies are price tak­ers and must ac­cept the price the mar­ket gives their com­mod­ity.

Go­ing neg­a­tive

some rea­son. So, go­ing back to the ho­tel ex­am­ple, now there are only 80 guests. Again, costs are largely fixed and hardly re­duce, even though there are fewer guests. So now rev­enue is down, but prof­its move lower at an even faster rate.

This neg­a­tive op­er­a­tional lever­age means that com­pa­nies with op­er­a­tional lever­age will have more volatile earn­ings. In the good times, earn­ings will in­crease at an ac­cel­er­ated pace; tough times will re­ally hurt.

Thus, com­pa­nies with op­er­a­tional lever­age should also be able to sur­vive dur­ing the tough times and then use the good times to ex­pand the busi­ness us­ing the ex­cess prof­its.

Work­ing it

to be able to con­tinue to pay it off when times get tough. So any ex­pan­sion dur­ing good times needs to be done cau­tiously. So, to use the ho­tel ex­am­ple, the ideal sce­nario would be one with a num­ber of ho­tels in dif­fer­ent re­gions around the coun­try (or, even bet­ter, glob­ally), and a bal­ance sheet that is not strained by the weight of debt.

There are of course com­pa­nies with very lit­tle op­er­a­tional lever­age. An ex­am­ple would be a con­struc­tion or man­u­fac­tur­ing busi­ness. With this sort of busi­ness ev­ery rand earned in rev­enue usu­ally has a cor­re­spond­ing num­ber of costs. So rev­enue growth and prof­its will move largely in tan­dem with each other.

This neg­a­tive op­er­a­tional lever­age means that com­pa­nies with op­er­a­tional lever­age will have more volatile earn­ings. In the good times, earn­ings will in­crease at an ac­cel­er­ated pace; tough times will re­ally hurt.

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