Why understanding operational gearing is key to successful investing

Business risk and operational gearing

The risk faced by a business is determined by lots of things, including its competitive position, the quality of its products and the state of the economy. All these have a big influence on how much profit a company can make.

Arguably, the key determinant of business risk as far as the investor is concerned is the relationship between a company’s revenues and its costs. This relationship is known as a company’s operational gearing, which measures the percentage change in a company’s trading or operating profits that arise from a 1 per cent change in its revenues. The more sensitive a company’s change in profits are to a change in revenue, the more operationally geared its profits are.

Taking time to understand a company’s operational gearing is one of the best things you can do if you are thinking of investing in the shares of a company. A company may be growing its profits very quickly because of it, but this may not be sustainable if revenues are unsustainable and start to fall.

Operational gearing explained

Companies with a large proportion of fixed costs – costs that have to be paid regardless of the level of revenues –  have more operationally geared profits. Examples of highly operationally geared businesses are transport companies, manufacturers or service companies that employ a lot of their own staff. Low operationally geared companies have mostly variable costs – costs that vary with revenues – such as retailers which buy and sell products. 

Most businesses have some fixed costs and therefore have some degree of operational gearing. Companies with high operational gearing will see their profits grow faster than their revenues when revenues are growing, but will see them shrink faster when they are falling.

Let’s see how this works out in practice. We have two companies with identical turnover and operating profit figures, but they have vastly different cost structures and therefore operational gearing. Far from being identical businesses, their profits will behave very differently to changes in revenues as shown in the table below.

Source: Investors Chronicle

The company with high operational gearing has a significantly higher fixed cost base and relatively low variable costs. These low variable costs allow it to have very high contribution margins – where contribution is defined as revenue less variable costs – but it has to sell a lot of its products or services to make a meaningful profit. The good news is that once the level of contribution has covered its very high fixed cost bill, each extra bit of revenue adds a much bigger proportional amount to profits. 

This is the leveraging of the high fixed cost base in action, or the operational gearing. Starting from a base revenue of 100, a 10 per cent increase in revenues leads to an 80 per cent increase in operating profits – the change in profits is geared eight times to the change in revenues.

Unfortunately, this gearing also works in reverse. A 10 per cent reduction in revenues leads to an 80 per cent reduction in operating profits. This kind of profit reduction is one that is likely to decimate the share price of the company concerned. This is what can make companies with volatile revenues and high operational gearing very risky investments.

The company with lower fixed costs has much lower operational gearing at three-to-one. Its profits don’t go up as much when its revenues are growing, but they do not fall as much when they are falling. This makes the company’s business less risky from an investor’s perspective.

The company’s operational gearing ratio can be calculated in a couple of different ways:

You can divide its contribution by its operating profit. Or you can take a company’s operating profit, add its fixed costs to that number and then divide the resulting number by its operating profit. You will get the same answer.

Armed with information about a company’s profit contribution and its fixed costs, it is possible to create a profit volume chart to see how a company’s profits will change at different levels of revenue. This assumes that the contribution margin will stay the same, which it might not if the mix of products and services being sold changes.

We can see from the chart that the company with high fixed costs and high operational gearing has to achieve a higher level of revenue before it makes a profit than the company with lower fixed costs. The slope of the profit/volume line is also steeper for the higher fixed cost business, which shows its higher operational gearing. To calculate the level of profit at any given level of revenue, take the level of revenue and multiply it by the contribution margin and then deduct the fixed costs.

The estimate of breakeven turnover is calculated as follows:

Fixed costs x (revenue/contribution)

For the high fixed cost business:

£70m x (100/80) = £87.5m.

For the low fixed cost business:

£20m x (100/30) = £66.67m

Understanding how operationally geared a business might be is very important for investors. A company may currently look very profitable because revenues have been growing and it has a lot of fixed costs. But if its revenues are not very stable and have a tendency to fall in a recession or are lost due to increased competition then you may be getting a false impression of a company’s sustainable profits.

Trying to get a feel of the company’s cost base and the stability of its revenues can be very insightful and helpful when researching a company. The only problem is that unless you are a company insider with a detailed view of its costs then it is very difficult to accurately calculate its level of operational gearing from its published accounts.

Going back to the last recession

All is not lost, though. As with many things in investing, history can be a useful guide to what might happen in the future. 

One of the most important things that I advocate to any investor is to look at how a company performed in the last recession, with particular attention to any evidence of large operational gearing effects. Unless the business is markedly different from what it was back then, there’s a good chance that history could come close to repeating itself when the next downturn comes.

As outside investors, we may not be able to accurately calculate operational gearing, but we can look at the past changes in revenues and profits to get a feel for the kind of operational gearing that might exist within the business.

Operational gearing effects do not always come from downturns in business volumes, but can also come from changes in the selling price of a product or service. This is very evident in businesses such as airlines where prices can move around a lot depending on levels of industry demand and supply. Given the industry’s high fixed cost base, profits have the potential to be very volatile.

I am going to look at a couple of different businesses over an economic cycle to look for evidence of significant operational gearing.

Somero Enterprises revenues and profits

Source: Annual reports

Somero (SOM) is a manufacturer of concrete levelling equipment. Demand for this equipment is cyclical and moves up and down with the economic cycle. You can see by looking at the trend in its revenues and profits that there is evidence of significant operational gearing on the downside in the last recession and on the upside in recent years as demand for its products has strengthened.

The company has recently warned that demand for its products has softened due to poor weather. As a result, revenues and profits are expected to fall this year, with profits falling faster than revenues as its operational gearing kicks in.

Somero has the high profit margins and returns on capital employed (ROCE) that are associated with companies that have high valuations attached to their profits. Yet at the time of writing, its shares trade on a rolling one-year forecast price/earnings (PE) ratio of 10.4 times.

I do not believe that this is a sign that Somero shares are extremely cheap, but more a reflection of its cyclical revenues and high operational gearing, which suggest that it’s not unreasonable to assume that its current high rates of profitability are unsustainable. Investors are not prepared to pay a high multiple of profits for the uncertainty and risks of this company.

easyJet revenues and profits

Source: Annual reports

Airlines such as easyJet (EZJ) have huge amounts of fixed costs, such as fuel, crew and leases that do not change with the number of passengers carried on its planes. The operational gearing within the business is therefore very large.

That said, there does not seem to be a set relationship between changes in revenues and changes in profits, as fuel – a large part of the cost base – is notoriously volatile and often complicates matters. Since 2007, you can see that easyJet went through a bit of a purple patch between 2009 and 2015 when profits increased faster than revenues. Subsequently, this relationship has broken down.

The key takeaway here is that profits are likely to be volatile and difficult to predict going forwards. This again largely explains why investors are not prepared to pay high valuations for the shares.

Very high profits from scalable fixed cost businesses

One of the most desirable things about a business with high fixed costs and potentially high operational gearing is when its revenues are relatively stable and growing and are expected to continue doing so. The ability of a business to leverage its high fixed costs with high contribution margins can see it become almost obscenely profitable as it gets bigger. This is because the costs associated with additional revenues once the fixed costs have been paid for are very low and therefore most of the extra revenues ends up as extra profit.

Businesses such as software, investment platforms and where manufacturing of its products has been outsourced – as in the case of Fevertree Drinks – can see the impressive leverage of its fixed costs and high operating margins as a result. These kinds of businesses have attracted very high valuations on the stock market.

Hindsight is all well and good, but if you can spot a business with a scalable fixed cost base in its early stages of growth then there can be significant potential to make a great deal of money from its shares. 

Businesses with scalable fixed costs and high profit margins

Source: SharePad