Let’s start today’s discussion with a short quiz. Which of the following two companies, in absence of any other information, would you like to own?
You might feel as if things are rigged in favour of Company B! But that is what it is. B happens to be better in every aspect as against A. They both operate in the very same industry, at the very same geography, with similar asset & consumer base. Trust me, similarities are abound between these two.. because they are one and the same company! Yes, company’s name is India Cements. Column A has its reported numbers for the fiscal year 2005 and B represents what it did in the year 2007.
Before you think of hitting me, scroll back to the title of the post. We are here to discuss about some ‘dreadful’ business combinations or business characteristics which can (and does) take underlying business for a ride from time to time and how should we think about these as long term owners.
Understanding operating leverage
So what is this thing strange stuff called ‘operating leverage’ and what it has to do with the above example?
Without falling back upon text book definition, let me give you an example about it. Imagine there is swanky new residential complex planned in outskirts of the town. You happen to be the lucky one eligible to receive a permit to build a descent sized general store just opposite to this particular project. So you have your store up and running while the project is just weeks away from final completion after which several families are expected to move here. And after 12-18 months’ time there would be enough guys living in this locality that you start cribbing about traffic jams 🙂
Now, at the very first month of opening the store, your income statement would be quite under red since whether or not customers start flowing in, store rent has to be paid out – just like some other maintenance expenses. And things would continue to be more or less the same over next couple of months. But once the store has celebrated its 2nd birthday, you would be at peace to see the $$ coming. Why so, what has changed? So while your rent, staff cost, electricity and other overheads being more or less the same, increase in footfalls has led to higher inventory off-take which means higher commission earning and your bulk buying from distributors would mean that you are even eligible for some volume discount. And since your inventory are now selling quicker, you are able to convert stock into cash faster than other retailers which means you are paying early enough versus other retailers to your distributors thereby making you eligible for sweet little cash / early payment discount.
As investor, if you were to look at the initial financial numbers of this particular store say of first three months, the losses staring back at you from the income statement would suggest that it was a big time mistake in the first place. And the financials of the last three months before the end of second year would surprise you such that you may find it difficult to tell if they belong to that very store.
There has been no turnaround in the store owner’s fortunes. It is just that his business is such that most of costs are fixed and there is particular threshold of sales over and above which it starts earning money. If footfalls are expected to sustain at its current levels, it would mean that store would continue to earn those returns in the foreseeable future and those initial losses are a history.
Operating leverage, cyclicality in business earnings & intense competition
It is one of the most dreadful combinations in the business world – you can face them individually but together they can take the bottom line for a spin. Remember the example of the ‘two’ companies above?
To explain the point, let’s take our store example further. Your store looks good since its footfalls are expected to sustain at the current levels, margin spread is more or less stable and your location is pretty close to the residential complex. Now, what if there are ten more stores opened up adjacent to your store selling the very same merchandise as your store offer? Competitive rivalry would be intense which means footfalls would turn to quite volatile – fluctuating between 250 walk-ins a day to 25 depending upon the offers you dole out. This would invariably reduce your margins are well. And remember your major cost items, apart from inventory, like rent, salaries, electricity are fixed. And this means that your bottom-line is meant to show severe volatility from bursts of lucrative profits (say due to some differentiated merchandise which takes off and which other retailers don’t currently have) to prolonged period to stress.
This is exactly why this combination is very daunting (and also why you frequently do not see ten store selling same merchandise side by side in a tight locality). But there are some businesses of which these three are more or less the regular factors. Analysing these is challenging for us who are looking to own under-priced securities.
Which are these businesses? What all factors should we consider while evaluating them? How to be sure that we are not over paying for these? These are some of the questions I would try to answer in my next post which I hope would add to our understanding of such businesses.
They aren’t necessarily always bad as ‘investments’ (unlike their underlying tough business conditions), it is just that we need to clear our lenses with which we look at these and set our expectations straight while thinking about them.