In general, high operational gearing is a double-edged sword for owners. High operational gearing occurs when fixed costs (which have to be paid regardless of the level of sales) make up a high proportion of total costs, which results in high sensitivity of operating profit to revenue.
On the one hand, high operational gearing enables the company to grow its bottom-line fairly quickly (when things go well). But on the other hand, it increases business risk, making it more difficult for management and investors to forecast future earnings.
We at Urbem think that a highly operationally geared business can be an attractive investment as long as it can meet the following criteria:
1) It generates recurring and growing sales;
2) It employs a scalable business model;
3) It is protected by some durable competitive advantage;
4) It is not highly financially leveraged;
5) It has a decent margin that can weather some cyclicality.
For the last point, readers may want to ask how "decent" is enough. In this regard, we think that history can be a helpful guide and suggest investors look at the business performance of the company throughout the last downturn. Take Graco (GGG, Financial) as an example. The Minnesota-based industrial specialist in fluid handling has an operating margin of 26% at the moment. During the great recession in 2009, the figure went down to 13% (primarily because of its manufacturing base and research & development spending), hitting a two-decade low. But the company then still managed not only to earn sizable income but also to outperform its peers in terms of profitability.
In terms of the first two points, we feel that businesses that are driven by software or platform, in particular, can often provide a high level of scalability and revenue stability. For instance, Oklahoma-based Paycom Software (PAYC, Financial) provides a one-stop human capital management solution on a Software-as-a-Service basis. About 98% of the company's total sales are recurring now. The revenue retention rate has been consistently over 90%, reflecting high client satisfaction as well as a switching-cost-based moat. Checking the historical financials on GuruFocus, we notice that the operating margin improved from 2.6% in 2012 to 30.7% last year.
Of course, well-moated growth companies with high operational gearing and an already high margin can be quite expensive. The share of Paycom is trading at a trailing 12-months price-earnings ratio of 98, a forward price-earnings ratio of 88 according to Morningstar earnings estimates and a price-to-free-cash-flow ratio of 176. We observe a similar valuation situation with some other businesses with high margins and scalable fixed costs: e.g., ATOSS Software (XTER:AOF, Financial), Intuit (INTU, Financial) and Rightmove (LSE:RMV, Financial). Mr. Market appears pretty good at appreciating high quality, once these companies have proved themselves to the public with a robust track record. If investors could spot this type of business early on, there should be a significant reward in terms of enviable alpha.
Disclosure: The mention of any security in this article does not constitute an investment recommendation. Investors should always conduct careful analysis themselves or consult with their investment advisors before acting in the stock market. We own shares of Rightmove.
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