In February of last year, I wrote an article called “The Peril of Operating Leverage.” In it, I said that simply put, a company with a high degree of operating leverage will suffer more rapidly declining operating income when revenues decline. Conversely, when revenues improve, the company’s operating income will increase more. Naturally this applies more to companies with high fixed costs than to companies with high variable costs, as the latter can cut costs (variable) more easily when revenue declines. The peril of operating leverage, unbeknownst to those investors who got caught off guard by the magnitude of decline in earnings power, should have played a vital role in the security analysis process.
The inverse of operating is also true - I’ll call it the beauty of operating leverage. The math is so beautiful and it mathematically illustrates why moats such as pricing power, advantage of scale and share buybacks work so well for wonderful businesses.
It’s time to walk through an example. Here I’ve pulled Brown-Forman’s (BF.B, Financial) 20 year financial data from GuruFocus and compiled them in a way that I think can illustrate the point.
The idea is that if you can have a business that grows revenue from pricing power and volume increases which is the case for BF.B, with economy of scale in both cost of goods sold and operating cost such that COGS grow slower than revenue and operating cost grows slower than gross profit, then you have first level of operating leverage working in your favor. If somehow other expenses and taxes grow slower than operating income, then you have the second layer of operating leverage to net income. If management then can buy back shares at great value, you add another kicker to earnings per share. All in, you can have a business that grows top line only at 3-4% but EPS at 9-10% with continuous margin expansion.
In the long run, stock price tracks fundamental growth; BF.B has grown its EPS at a CARG of 9.1% a year and the stock has generated price return of 12.0% and total return probably 13% a year including dividend. It seems to me that the current stock price appreciation has outpaced fundamental growth, but that’s a different topic.
This pattern applies to many of Berkshire’s businesses such as Coca Cola (KO, Financial), American Express (AXP, Financial) and See’s Candy. The trick is to assess predictability of the business because operating leverage can work against you, as we can easily see in retail and energy businesses.
