The ins and outs of operational leverage
When a company’s profits increase at a faster rate than its revenue, it has leverage. But how does this occur?
operational leverage is one of the beauties of investing. That occurs when companies are able to increase profits at a faster rate than they’re increasing revenue. The cherry on the top is when dividends are able to increase at a still faster rate than both revenue and profits.
Which sectors can benefit from operational leverage?
The easiest example of this can be found in any fixedcost business, such as a mining company. The cost of extracting whatever it mines from the ground is relatively fixed, with adjustments for inflation. But the payment it receives for whatever it mines could be increasing at a faster rate than inflation is driving costs up. When this happens, the revenue will increase, but profits (and potentially dividends) will soar as most of the extra revenue goes straight to the profit line.
Other industry examples are the hotel and hospital sectors. Their cost base is largely fixed, so if a hotel can increase bed nights the profit jumps as the increase in bed nights does not directly increase the costs of running the hotel or hospital. So, an extra 5% in bed nights could see profits increasing by 15% or even 20% due to the nature of the largely fixed costs. This will also result in dividends increasing even faster.
Of course, this cuts both ways for miners, hotels and hospital groups. If revenue drops due to lower commodity prices or fewer bed nights being utilised, then profits will fall even faster. Hence you really want to own these stocks when the leverage impact is expanding and creating increased profits. Falling revenue with a largely fixed cost base can be very harmful to profits.
There is also another leverage impact which we see in more traditional industries such as retail. Typically, retail profits rise and fall in line with sales increases or decreases since these players receive a set profit per item sold. Sure, increased sales do make stores more efficient and could also result in the supplier offering goods at a better price, thereby boosting margins. Retail also has largely fixed head office costs, thus resulting in a modest amount of leverage to the profits.
Two recent sets of retail results show that even retailers can increase efficiencies and hence increase profits and dividends ahead of revenue increases.
First, the Pick n Pay results saw revenue up by 7% while headline earnings per share (HEPS) increased by 18%, as did the dividend. In this example this was in large part thanks to improving operating margins as they continue to cut costs under the relatively new leadership of Richard Brasher. The other recent example is Clicks, whose results saw revenue up by 8.5%, diluted HEPS up by 13.5% and the dividend increased by 15.8%. This is exceptional and is an indication of a superb top management team. Here there are very few extra costs to be removed from the business, because this has been a tightly run company for a long time.
In this case, the leverage impact to both profits and dividends is really about extracting ever-increasing efficiencies from the businesses. In the case of UPD, the group’s pharmaceutical distributor, it was achieved by managing costs but also by managing inventories. At Clicks stores results were driven by the new deal with Medicross and Netcare as well as inventory management and slightly increased efficiencies across the group.
The management team of a company is critically important, but it is often very hard to get a real sense of how good they really are. Is the increase in revenue and profit due to their expertise or is it more of a general industry trend? Checking for this leverage effect can help identify quality management versus average management, and certainly Clicks’ management is one of the best in this regard.