Operational Leverage for Exponential Effects to Compound Shareholder Value

Over the past few weeks, I have shifted my thinking towards companies with operating leverage coupled with network effects.

Why Network Effects?

In Morningstar‘s approach, the firm views economic moats as below:

Generally, I do think moats are derived from the business model design, creation and offering a superior product/services that the end customers desire. I see network effect as #1 moat among all moats.

[Intangible Assets] There are several brands that have intangible assets yet what are brands these days? Do people stick and be loyal to a certain brand for a long time? There are always alternatives. I can drink Coke, or something else. It is increasingly difficult to convince the market place that your brand is worth the premium. It is not a must-have for customers. As a consumer, there are a few companies with intangible assets that translates to real economic benefit for the firm. Some examples are LVMH Moët Hennessy, or Ferrari N.V.,

[Cost Advantage] If I am a furniture company based in Malaysia, I would have comparatively cheaper access to my furniture supplies compared to another similar firm operating in Singapore. Again, if I am a manufacturing company, I would have cheaper labour operating in Vietnam versus another similar firm operating in China. Yet… are these durable moats? The Singapore firm would be able to close up the cost advantage given 1 – 2 years by shifting their operations to the mentioned countries.

[Efficient Scale] If you are a busy that does not produce good products and services, it is very easy for your competitors to sneak behind you and capture your market share. In Australia’s context of Woolworths and Coles, they are known as a duopoly for many years until…. Aldi appeared and stole their market share. Isn’t Woolworths and Coles, the incumbents enjoying efficient scale? I don’t see it as a durable moat, once again.

[Switching Costs] I recognise that switching costs is really painful. Think of the perspective of a teleco subscriber, it takes some effort to change telco. But I did, I switched because the other telco was offering much more value. Microsoft and Apple users are known to be very loyal to their operating systems (Windows and Mac OS). Are there people who switched, eventually? Yes if they see the value in the competing product.

[Network Effects] I’ve seen companies grown exponentially because of network effects. Consider Facebook and Tencent’s platform growth, they are incredible. The growth in numbers adds and strengthens the moat of the company. The more content that is available in the platform, the more sticky I am to the platform. Despite the Facebook scandal that broke out, no one was really bothered to leave Facebook permanently. Low marketing costs. Increasingly, you’ve seen how firms with supposed moats (efficient scale, switching cost, cost advantage, intangible assets) are leveraging on companies with network effects to gain market share and more awareness. Network effects is measured by the number of users or the content being shared.

Operating Leverage

Operating leverage is a measurement of the degree to which a firm or project incurs a combination of fixed and variable costs. A business that makes sales providing a very high gross margin and fewer fixed costs and variable costs has much leverage.

https://www.investopedia.com/terms/o/operatingleverage.asp#ixzz5FRMRvP48

In short, operating leverage occurs when a business does not need to fork out extra expense to service or deliver products to its customers. Operating leverage happens when fixed cost is high while variable cost is low.

There are positive things and negative things about operating leverage which I will explore together with you.

Think about it for a moment….

If you are theme park operator, and you have the best theme park experience in the whole wide world. You will face some seasonality in your sales. For example, you’ll do really well during holiday periods, and you’ll do okay during normal periods.

During holiday periods and normal periods, is your daily costs to run the theme parks relatively fixed? Yes. Perhaps, you will do 1 or 2 more shows during the holiday seasons.

How does it translates on a company’s profit and loss statement using two scenarios?

Why is there such a huge difference in terms of operating margin? The answer lies with the fact that once a business covers its daily fixed costs, any additional revenue earned… it flows down directly to the operating profit.

In this case, once the revenue of $300k covers the fixed costs of running the theme park, the excess becomes operating profit after deducting the minimum variable costs.

What happens if it is the opposite? The theme park attendance suffered because of bad weather throughout the month.

You can see the entire profit and loss statement changes dramatically. This is because revenue (sales) are unable to cover the fixed costs of running the business.

To find out how much sales is required to break even, the formula is “sales x gross profit margins = fixed costs“.

So all of us can see that operating leverage is a double-edged sword.

Apart from theme parks, what are some other businesses that has operating leverage?

Universities – when a teacher is being hired, a teacher is able to teach up to 20-30 students at one go. If the class size is currently undersized, the school is able to take in students without hiring extra teachers. Most of the school fees (sales) are operating profits.

Gaming – when I was playing this game called Candy Crush, I paid money for extra gaming benefits. King (the developer) do not have to incur extra expenses to deliver the benefits to me. It is all pixels, anyway.

Gambling – when there are more gamblers in the casinos, the gaming slots and VIP tables will be more crowded. Those companies do not have to hire significantly more staff to service them. They maintain a reasonable number of staff at all times, so it is generally fixed costs.

Social network – when there are more users signing up for a Facebook account, does Facebook have to incur huge amount of expenses? Most of the time, they would just need more database and server capabilities. When more advertisers start to use Facebook services, is it automated or is there a representative who will service them? Most of the time, it is automated and a representative can take up to >6-15 high-spending accounts reasonably. This is why, the gross margins for Facebook is around >80%.

You can see very clearly that the revenue increased by 49% in Q1 FY2018 while the expenses increased by a proportionally lesser amount at 39%, this causes the operating profit to grow by 64%. That’s operational leverage. Facebook’s revenues are far enough to cover the fixed costs. The fixed costs should not increase that much as Facebook is a network business, however, as we know, they are growing their fixed costs because of security investment.

Let’s look at another company called IMAX.

IMAX has operating leverage because costs are fixed while the revenue is a variable percentage of the box office revenue.

Total revenue increased by 23.8%

Total costs and expenses increased by 4.3% (much lower than revenue growth!!)

This resulted in…. gross profits growing by a massive 41.7%.

Combination of both

One can see operating leverage swings both way from the theme park examples. To protect our hard-earned capital, it would be wiser to search such companies with network effect. Some good examples are Booking.com, TripAdvisor, Expedia Group, Tencent, or YY Inc. There are probably a lot more.

As this point of writing, I am not vested in any of the companies mentioned. 

However, not all fantastic companies are good investments. We always desire to buy it at a good price. Hope you enjoy this piece, leave a comment or reach out via Twitter (@Kelvestor)

This piece is inspired by Michael Shearn. You can find my comments on his fantastic book over here.