The Double-Edged Sword of Operating Leverage

Operating leverage is an important concept to consider when analyzing any business, mainly for its potential to cause unexpected step-changes in the earnings of a company. It is crucial to understand what exactly operating leverage is and the implications that it has for identifying investment opportunities.

The chart below breaks down the elements that combine to create operating leverage within a business. As can be seen, the “operating margin β”, or operating leverage, is driven by both changes in sales and changes in cost. What is key to note from the below conceptual framework is that changes in sales will have different effects on earnings, depending on the nature of that firm’s cost base.

Usually a company will have some proportion of both fixed costs and variable costs; operating leverage can be thought of in terms of the ratio of fixed to variable costs[1].

• Fixed costs refer to costs that don’t move proportionately to sales. As such, if sales decline, fixed costs remain unchanged and this can trigger a greater-than-expected fall in earnings. Conversely, a company with high levels of operating leverage can experience dramatic increases to earnings when sales grow.
• Variable costs move in concert with sales. A highly variable cost structure reduces operating leverage for a business, given that changes in sales are accompanied by a corresponding change in costs.

The below chart helps illustrate how different levels of fixed costs impact operating leverage.

Consider Company A, a software developer with a cost base comprised of 75% fixed costs, and 25% variable costs. Company A has a largely fixed cost base and is represented by the blue line in the above chart. As a software developer, Company A must incur significant expenses to develop software programs. These software development expenses can be thought of as “preproduction costs”, whereby Company A will incur expenses to develop software programs before it can earn any revenue.

Contrast this with Company B (represented by the red dashed line in the above chart), a plumbing business where incremental revenue is earned by a plumber working more hours. Said another way, Company B must pay someone to produce each dollar of revenue, such that there is a strong relationship between revenues and costs.

Referring again to the chart above, the operating margins of both Company A and Company B are 20% when sales are $10m. However, the effects of operating leverage become apparent when there is a change in the sales base for these companies:

Scenario 1 – Sales increase to $25m:

• In this event, Company A’s operating margin expands dramatically to approximately 60%. It needs to incur only minor expenses to support these additional revenue streams (i.e., packaging and distribution costs), given that the bulk of its costs have already been incurred in order to produce the software.
• The impact on Company B is far more muted, with the operating margin expanding to just 30%. The $15m of additional revenues can only be earned by using more labor (in this case plumbers), and this causes Company B’s costs to increase in response to this revenue increase.

Scenario 2 – Sales fall to $5m:

• Company A, due to the fixed costs it must incur to generate software content, is unable to reduce costs at a fast enough rate to offset the sales decline. Consequently, Company A’s margin reduces to -40% under this scenario.
• Company B fares much better in this declining sales environment, with its margin falling to around break even. As sales reduce for Company B, there is a commensurate reduction in costs as less labor is used.

An understanding of this operating leverage framework is particularly powerful when identifying stock candidates for the Montaka portfolio. For example, industries facing structural headwinds, where there are pressures to revenues that are unlikely to quickly abate, can present opportunities on the short side, particularly when these revenue declines are coupled with a high fixed cost base. Conversely, finding businesses with large organic growth opportunities that require only modest levels of fixed cost investment can also present attractive long investments.

Given the tendency of people to extrapolate the recent past, and to forecast in a relative narrow band of outcomes, the acceleration or deceleration of earnings growth that operating leverage is capable of producing can create stock mispricings. The Montaka team tirelessly seeks to find these opportunities and can take advantage of such situations on both the long and short side.

[1] Operating Leverage: A Framework for Anticipating Changes in Earnings (2016), Michael J. Mauboussin.

George Hadjia is a Research Analyst with Montgomery Global Investment Management. To learn more about Montaka, please call +612 7202 0100.