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?

Finweek English Edition - - MARKETPLACE - Ed­i­to­rial@fin­

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.

Real-life ex­am­ples

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.

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