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Three reasons to understand how a company operates

We explore why understanding how a company works, not just what it does, is important to investors.

Important notes

This article isn’t personal advice. If you’re not sure whether an investment is right for you please seek advice. If you choose to invest the value of your investment will rise and fall, so you could get back less than you put in.

It’s important to look at how a company operates, not just what it does. A company could have a great product but if getting to that end product is a clunky process, profits can suffer.

Slick operating models tend to make a business more efficient, and can improve margins and make expansion easier. All that can contribute to higher profits, and in some cases, returns to shareholders. Although remember, there is no guaranteed recipe for success.

Here we take a closer look at three companies that have found success with three different models.

This article is not personal advice. If you are unsure whether an investment is suitable for you, take advice. All investments and income can fall as well as rise in value so you could make a loss. Past performance is not a guide to the future.

Franchising checks-out

Franchisees pay for the right to use a company’s branding.

That’s an attractive set up because it creates extra revenue streams, either through profit sharing or flat fees, for the brand owner. It also means less money gets tied up in owning and maintaining lots more properties.

This operating model is particularly popular in the food industry. The likes of Dominos, Subway and McDonalds use franchise models, so next time you pick up a bite from any of these, chances are you’re not technically buying it from the business you thought you were.

Franchising is also often a feature in the leisure market, with one of the biggest being InterContinental Hotels Group (IHG). Within a global estate of 856,000 rooms, IHG makes almost all of its operating profit from the fees it charges hotel owners, rather than by owning rooms themselves.

It licenses its brand to hotel owners for a fee, who benefit from receiving reservations from IHG’s central website. All-in-all, it’s a very capital light way to make money, and the benefits are there to be reaped by shareholders.

By not being bogged down with costs, IHG has the freedom to give extra money back to shareholders. $500m in special dividends was paid in the first half of this year, although all dividends are variable and there are no guarantees this can be repeated.

Of course, operating a franchised business doesn’t solve all the issues around operating a hotel group. IHG is very exposed to the ups and downs of the economies of the countries it operates in. In the face of a downturn, leisure and corporate clients limit spending on plush hotel rooms and meeting spaces. Political and economic landscapes remain jittery, and all this at a time when IHG has a record number of rooms to fill.

The shares trade on 19.4 times expected earnings, which suggests analysts hopes are high for the future, and the shares would be sensitive to disappointment. Overall though, a strong brand and flexible business model should hold IHG in good stead over the longer term.

Find out more about IHG

Fast fashion can pay dividends

Not every fashion store is in need of a helping hand at the moment.

Spain’s Inditex, or Industria de Diseño Textil to give its full title, has Zara as its biggest brand, with the likes of Pull & Bear under its umbrella too. We think its operating model has a lot going for it.

Its global manufacturing and distribution network means it’s been able to keep up with the e-commerce boom in a more cost effective manner than peers. That nimble network is also behind ambitious plans to have all of Inditex’s brands available online, anywhere in the world, by 2020. Not many traditional fashion retailers can boast that.

Beyond the online empire, Inditex’s mode of operation is impressive in other ways. It makes and designs its own clothes, which not only helps with cost efficiencies, it means it can respond rapidly to changing trends. That makes Zara a go-to shop for fashion savvy customers, and helps support more premium price tags. The average basket size at Zara is €60, which is more than the standard New Look shopper is likely to part with.

For all that, the fact remains retail is a tough place to be. A valuation of 20.6 times expected earnings is lower than the group’s historical average, but higher than several peers. That shows investors have bought into the belief Inditex is doing things a bit differently, and they expect results to match. Operating profit growth of 9% to EUR4.4bn last year wasn’t enough to satisfy analyst expectations.

On the positive side, like-for-like sales are expected to keep moving in the right direction, which isn’t something everyone else is managing. And the group has an impressive net cash position too, which fed into shareholder returns of €0.88 per share last year – a quarter of which came from special dividends.

Inditex is an impressive business, and its agile operation methods means it’s managed to create and maintain a significant grip on the retail market. Investors will still be hoping consumer spending rises soon though.

Find out more about Inditex

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Easy moving

Rightmove’s raison d’etre is to make “home moving easier”. And it’s true, the website has revolutionised how the nation browses and advertises houses.

While users spend a collective one billion minutes a month on the site, what they might not realise is Rightmove isn’t just making their lives easier, the group has a pretty easy time of it too.

That’s because Rightmove’s business, running a website, doesn’t cost a lot. As the group underwent huge expansion, costs were kept to a minimum, and as such margins are around 77%. That’s among the highest in the FTSE 100.

The other string to its bow is the fact it’s a must-have portal for traditional estate agents, which allows Rightmove to keep pushing its prices up. Last time we heard from the group, it was raking in £1,077 per branch, per month. That pricing power is particularly important, because it’s offsetting declines in the number of estate agents on the high street – down 3% at the half year.

If agents keep closing, and are replaced by online competitors, the group may need to rethink its pricing structure (charging per branch, per month) in the future.

Still, it’s hard not to be impressed by Rightmove’s market domination. At 1.5%, the yield isn’t flashy, but a healthy – and growing – net cash position means dividends are well underpinned, and means we think there could be increases in the future. Please remember though that yields are variable and are not a reliable indicator of future income.

A price to earnings ratio of 24.7 is similar to the ten year average, but lower than the more lofty ratings of 2014-15. That could reflect how leaning on the UK property market could prove problematic if there’s tougher times around the corner.

But when all’s said and done, we think Rightmove is an impressively efficient business.

Find out more about Rightmove

Unless otherwise stated estimates, including prospective yields, are a consensus of analyst forecasts provided by Thomson Reuters. These estimates are not a reliable indicator of future performance. Yields are variable and not guaranteed. Past performance is not a guide to the future. Investments rise and fall in value so investors could make a loss.

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.

Important notes

This article isn’t personal advice. If you’re not sure whether an investment is right for you please seek advice. If you choose to invest the value of your investment will rise and fall, so you could get back less than you put in.

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