How to make sense of profits post-pandemic

Between 2012 and 2020, revenue at online automotive marketplace Auto Trader rose 76%. Even more impressive, operating income more than doubled. How was the group able to grow profits at more than double the rate of sales? The answer is operating leverage.

Operational leverage measures the impact of each additional pound’s worth of revenue on operating profits. Companies with a high degree of operating leverage sell every additional unit at a higher margin than the last. That’s because once fixed costs, like head office costs and rent, have been covered, they need to spend very little to deliver each new sale.

Platform businesses, like Rightmove or Auto Trader have tended to do this very well. They spend a lot to develop a platform, but once it’s built each new listing costs very little. That can make these sorts of businesses potentially very attractive investments, assuming of course that they can steadily increase sales. As with any investment there are no guarantees.

This article isn’t personal advice. If you’re not sure if an investment is right for you, ask for advice. All investments fall as well as rise in value, so you could get back less than you invest. Past performance isn’t a guide to the future.

The truth about operating leverage in a post-pandemic world

Take this example:

Company A sells 10,000 widgets for £10 each. The raw material to make each product cost £2, and the company also has relatively high fixed costs at £50,000 (these include the rent for the company’s factory and salaries for certain key admin staff).

Company B sells 10,000 widgets for £10 each. It also costs £2 in raw materials to make each product, but fixed costs are lower at £10,000.

With sales at this level, Company B is clearly a more attractive investment. It enjoys a profit margin of 70%, to Company A’s 30%.

But what if sales at both companies rose 50%?

Company B remains a more attractive investment, but look at what’s happened to profits. Company A’s profits have more than doubled while Company B’s profits are up ‘only’ 57.1%. This is operating leverage in action. Company A will become increasingly appealing if revenue continues on this trajectory because its earnings growth will outpace Company B’s.

High fixed costs might not make a company an attractive investment, but they mean additional sales can quickly boost profits. And rapidly rising profits can mean good news for valuations, although past performance isn’t a guide to the future.

The highs and lows of operating leverage

High operating leverage can be a huge draw, particularly in industries in their infancy. Social media is an example of this. Companies had to spend big in order to set up the platform, paying developers and buying servers. But once it’s been created, they can push it out to millions of people at little to no cost.

High levels of operating leverage can also become a burden though. In the example below, if demand drops to 4,000 widgets, Company A is in the red. Company B remains comfortably profitable because its fixed costs are much lower.

When the economy takes a turn for the worse, revenue can nose-dive as consumers tighten their purse strings, making it more difficult to cover fixed costs.

Airlines have this problem now. The cost to fly a plane from Europe to the US is pretty much the same whether it’s sold out or empty. The number of people willing to pay for a ticket determines whether the airline will be profitable or not. If the plane doesn’t go at all, the company still has to pay interest on the debt it took out to buy the plane, as well as maintenance costs. If it doesn’t own the planes outright, it will have to pay leasing fees too.

How to use operating leverage

Like most other financial metrics, it’s best to compare operating leverage within a single industry. If you’re looking at two similar companies operating within the same sector, higher operating leverage is almost always preferable.

Unfortunately, there’s no perfect way to calculate operating leverage exactly, because you’d need detailed information that isn’t always available to the average investor. However, you can get a rough idea by comparing changes in operating profits to changes in sales revenue.

Degree of leverage ≅ % change in operating income/ % change in sales revenue

Take online property marketplace Rightmove, for example. The group’s operating profit rose 468% between 2009 and 2019. Revenue rose by 317%. The degree of leverage is therefore roughly 1.5. That tells us that an extra £1 of revenue has translated into £1.50 of profit. Remember these figures are only estimates and shouldn’t be looked at in isolation, but they offer a useful comparison tool.

The bottom line on operating leverage

Companies with high operating leverage have the potential to grow profit quickly in the good times. But as we’ve seen that can work in reverse too. Having an idea of the operating leverage in a business helps you to gauge the risks of an investment.

If sales in the future look uncertain and operating leverage is high, then there’s a real risk the company could fall to a substantial loss. By comparison if you think sales in a particular industry are set to rise substantially, you might want to look for a company with a high degree of operating leverage. That’s because its profits will grow quicker than rivals during a sales boom.

Ultimately operating leverage has the potential to increase returns, but also to increase risk. Weighing up that balance between risk and reward is what investing is all about.

Investing in individual companies isn’t right for everyone – it’s higher risk as your investment is dependent on the fate of that company. If a company fails, you risk losing your whole investment. You should make sure you understand the companies you’re investing in, their specific risks, and make sure any shares you own are held as part of a diversified portfolio.

This article is not advice or a recommendation to buy, sell or hold any investment. No view is given on the present or future value or price of any investment, and investors should form their own view on any proposed investment. This article has not been prepared in accordance with legal requirements designed to promote the independence of investment research and is considered a marketing communication. Non-independent research is not subject to FCA rules prohibiting dealing ahead of research, however HL has put controls in place (including dealing restrictions, physical and information barriers) to manage potential conflicts of interest presented by such dealing. Please see our full non-independent research disclosure for more information.

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